Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.
Editors’ Note: MarketMinder’s commentary is intentionally nonpartisan. We favor no party nor any politician and assess developments solely for their potential market and economic effects.
Last week, the US Treasury announced gross national debt exceeded $31 trillion for the first time and, predictably, the huge number spurred myriad concerns. Chief among them: Rising interest rates mean higher borrowing costs—so does that mean America’s finances are in trouble? We don’t think so.
As a lot of coverage noted, the $31 trillion figure refers to gross debt—i.e., total debt outstanding, which includes debt owned by the Federal Reserve, private investors and intragovernmental agencies. We think it is more accurate to focus on net public debt (i.e., debt held by investors and the Fed), which is $24.3 trillion—and not because the figure is smaller.[i] Rather, net public debt excludes the money the government owes itself, which effectively cancels. (You can read more about that here.)
September’s Consumer Price Index report hit the wires today, and once again, inflation data sent Fed watchers into a tizzy. While the headline rate slowed from 8.3% y/y to 8.2%, the “core” rate, which excludes food and energy, accelerated to 6.6%—a fresh multi-decade high.[i] Unsurprisingly, rate hike expectations jumped, with most market participants now seeing the fed-funds target range topping 4.5% by 2023’s end—and a growing minority now envisioning rates topping 5% by then.[ii] That is a big change from yesterday’s expectations, and it was initially enough of a jolt to send market sharply lower. The S&P 500 opened down around -1.6% from Wednesday’s close, and 10-year US Treasury yields jumped from 3.91% to a high of 4.22%.[iii] But as the day progressed, the moves reversed. The S&P 500 closed up 2.6% on the day and the 10-year yield flipped to finish at 3.94%.[iv] While we hesitate to read much into a wobbly day, we see a couple of interesting lessons to draw here, and we think they provide reason for optimism.
Why is always harder to know than what, but we doubt 10-year yields’ reversal stems much from Fed predictions, which remain high. Best as we can tell, the bigger development is the rampant chatter about the UK government plotting another U-turn on its recent “mini-budget” and will soon announce it doesn’t plan to cancel next year’s corporate tax hike after all. This seems to have radically shifted sentiment toward UK Gilts: British 10-year yields are down almost -33 basis points on the day as we write. Their decline has helped pull rates down globally, and if you look at an intraday chart of the US 10-year yield, you will see an initial decline that paralleled Europe, then a sharp spike as the inflation data came out, followed by a renewed decline—which in turn parallels stocks’ rise.
So, we would venture that the inflation report—and its impact on rate hike expectations—caused a fleeting sentiment jolt global factors soon overrode. This is unprovable, as most explanations for daily market movement are, but we think it is useful as a working hypothesis. Now, ordinarily we wouldn’t dwell on such things, but stock returns and bond yields have been very negatively correlated lately, which is rather unusual. Since 2000, the rolling 3-month correlation between weekly S&P 500 price returns and the weekly change in 10-year Treasury yields has been more negative than it is today on only four occasions.[v] To us, this is a strong indication that bond market freakouts are spilling over into stocks right now. So when rate hike expectations and UK Gilt volatility took Treasurys on a wild ride Thursday, stocks rode shotgun.
Of all the investing maxims we have seen, we can’t recall any that included “sell low” as timeless advice. More often, it is a thing people do out of panic, then regret later as a market recovery leaves them behind. But what if you have no choice? That is the situation retirees may be facing if they haven’t yet taken their annual mandatory minimum withdrawals from their traditional 401(k)s and IRAs this year. The prospect of reducing stock exposure at levels well below early-year highs—thereby reducing exposure to the eventual rebound—is far from attractive. Thankfully, there are ways to lessen the blow.
Yes, those who turned 72 this year and older with tax-deferred retirement savings accounts must take required minimum distributions (RMDs) or risk facing a stiff 50% penalty on the amount not withdrawn. What is your RMD? Divide last year’s ending balance for your tax-deferred plan(s) by your—and perhaps your spouse’s—remaining-year life expectancy, which the IRS helpfully estimates (Uniform, Single, Joint). Or, ask your financial professional to tabulate it for you. This is the minimum amount you must withdraw this year—which is then subject to taxes. It is how Uncle Sam ensures he gets his slice of those long tax-deferred monies.
Federal law mandates retirees withdraw these funds. But they don’t mandate what you must do with them, which gives people some flexibility. If you don’t need the money straight away and can cover the taxes, you might find it beneficial to withdraw your RMD amount in-kind—simply transferring securities into a taxable brokerage account in the amount required. You still have to pay taxes on the withdrawal, but this lets you stay invested. Then, you are able to sell at your discretion when you need to raise cash for living expenses or other purposes.
Contagion. That is the word many pundits latched onto Monday, when the Bank of England (BoE) announced new support measures for pensions forced to sell Gilts to meet sudden margin calls. When the trouble first erupted two weeks ago, a vicious circle of rising interest rates and forced selling prompted the BoE to offer to step in as Gilt buyer of last resort for pensions to stop this technical issue from roiling broader markets. That stemmed the tide for a while, but another 10-year yield spike Monday to a fresh closing high of 4.55% accompanied more intervention to “reduce risks from contagion.”[i] There is a lot more to that sentence, as we will discuss, but much of the coverage buried the context, and the hunt for the next shoe to drop began. We aren’t dismissing the UK bond market ructions, but we don’t think this is a 2008-scale financial crisis in waiting.
For simplicity, we will avoid rehashing the political backdrop other than to say yields initially spiked when the market overreacted to the new government’s “mini-budget” that attempted to offset a stealth tax increase with tiny tax rate cuts. For our purposes today, it simply matters that when long rates jumped, it triggered some problems in a corner of the UK pensions market called Liability-Driven Investing (LDI), which—as the name implies—is a tactic pensions will use to match their investments with their future liabilities. In practice, this is easier said than done, as some active pensions have unfunded liabilities, meaning they are still accepting new participants, don’t know what their actual benefits payments will be and still need to earn a long-term return to be able to pay benefits to all participants. As a result, many funds will invest in stocks and other securities as well as bonds, which earns the needed return over time but also subjects the pension’s total value to market volatility in the interim. Enter LDI, which uses interest rate swaps and other derivatives to hedge against market movement in order to keep a portfolio’s market value (and funding ratio) more stable when volatility strikes.
We won’t get into the technicalities of all these contracts, as that too is beside the general point. All you need to know is that a lot of funds used LDI to get leveraged exposure to fixed income in order to increase returns when yields were low. The derivative contracts were designed to rise in value when interest rates fall, but when rates rise and values fall, it requires pensions to post more collateral to meet their margin requirements.
After a strong start, stocks retreated to close the week, with the S&P 500 down -2.4% as we type early Friday morning.[i] The culprit for the day’s selloff, according to most accounts, was September’s US employment situation report, which showed an unexpected dip in the unemployment rate and nonfarm payrolls rising by 263,000.[ii] A few outlets noted that the pace of hiring has continued to slow—from 315,000 in August and 537,000 in July, and an average of 493,000 in the 12 months prior to Friday’s report. Yet given jobs growth remains quick, most outlets quickly dismissed that: Yeah but the Fed still needs to do more was the common theme, implying we will eventually get to a point where the Fed must kneecap the economy in order to tame the inflation beast, lest it risk allowing a hot job market to fuel a wage-price spiral. We don’t buy this thesis, and we think investors would do well to understand why.
Conventional wisdom—and the Fed’s dual mandate of seeking maximum employment with stable, low inflation—hold that the job market drives wage growth, which drives inflation. Ergo, the Fed should raise interest rates to cool hiring in an inflationary environment like the present and cut them to spur hiring when unemployment is up. Nobel laureate Milton Friedman shattered this myth decades ago, and simple logic does the same today. He showed inflation drives wage growth, not the other way around. Think about it from a worker’s perspective: When are you most apt to hound the boss for a raise? When your rent hasn’t gone up for years, food prices are stable and gas is reasonable? Or when you are suddenly faced with a 10% premium to renew your lease, a newly astronomical grocery bill and much higher fuel prices? Employers understand this too and factor recent inflation into their wage and salary offers. If it were the other way around—if companies randomly raised wages, then prices, then wages, then prices—then inflation would be a merry-go-round that never stops and would start for basically no reason. Money supply growth, supply chain issues and all of the things that have actually driven inflation this year wouldn’t matter.
Secondly, there just isn’t much the Fed can do right now, in a practical sense, to affect hiring noticeably. Traditionally, it would try to control money supply growth by using its benchmark interest rate to influence the yield curve—Fed controlling the short end, market controlling the long end. The gap between the two (long rates minus short) would influence banks’ net interest margins on new loans, as banks generally borrow at short rates and lend at long rates. Banks aren’t charities, so the potential profit margins would influence their willingness to lend at borrowers’ varying degrees of creditworthiness. For good measure, the Fed would also raise or lower reserve requirements to give banks a shorter or longer leash. In a fractional reserve banking system like ours, banks create a large share of new money through lending, so enabling more lending would boost the money supply, which in turn would driver faster growth and more hiring. Disabling lending would slow money supply growth, cooling the economy and tamping down job growth. The relationship between the quantity of money and the amount of goods and services available for it to chase would determine inflation.
As stocks finished a frustrating Q3 last Friday, America, China and Japan released some widely followed economic data. While the figures are backward-looking, they show ongoing resilience in the world’s three largest economies—evidence reality has held up better against myriad headwinds than many seemingly expected.
Resilient US Consumer Spending
First up: US personal consumption expenditures (PCE). This inflation-adjusted consumer spending measure includes goods and services—a contrast to the retail sales report, which isn’t inflation-adjusted and omits most services spending.
Stocks had another big day Tuesday, but it hasn’t done much to help sentiment as headlines continue stewing over the latest fear: the strong dollar. Some warn it is a negative for the US itself, as a strong dollar hits US-based multinationals’ overseas revenues (never mind that it also reduces their overseas costs and most international earnings don’t get repatriated and converted to dollars). Others focus on international stocks, warning their weak currencies are a headwind and are causing them to import even faster inflation. Add in actual currency market intervention in Japan plus talk of the same in South Korea and China, and currency chaos is top of mind. In our view, this is more a sign of sentiment than an actual negative for stocks, as we will show.
Re-read the prior paragraph carefully, and you may notice a weird inconsistency: the concerns about the US directly contradict the concerns about Europe and Asia. If the strong dollar is supposedly bad for the US, then that implies a weaker dollar would be better. Yet we are also told a weaker currency is a massive headwind in Europe and Asia, implying they would benefit from the stronger currency that is supposedly a massive risk on our shores. Absent some mythical Goldilocks exchange rates, which we have never seen theorized ever, there is no way to make it make sense.
If theoretical arguments aren’t your thing, then consider Exhibit 1. It shows a smattering of major developed and Emerging Markets’ currency moves year to date, along with their year-to-date stock returns in their home currencies and US dollars, their highest inflation rate in 2022 thus far and their most recent inflation reading. As you will see, there isn’t much evidentiary support for today’s prevailing fears. The US, which has the largest currency appreciation, is in a bear market. Brazil, which has the second-best currency of this bunch, has positive year-to-date returns in its home currency. Yet Mexico, whose currency is also up this year, is down double digits in pesos. As for the eurozone’s four largest economies, Germany is down over twice as much as Spain, and the corresponding inflation rates are all over the map. The UK has the second-weakest currency but is down just single-digits, albeit with double-digit inflation. Yet Japan, where the yen is down more than -20% on the dollar, has the second-lowest inflation rate.
The good kind of volatility returned Monday as the S&P 500 jumped 2.6% to start Q4.[i] But stocks weren’t the only thing that rose. Crude oil prices also jumped, tied largely to rumors that OPEC and its partners are considering reducing their production target by a million barrels per day (bpd) at this week’s meeting. Cue fears of a big cut fueling (sorry) another spike in oil prices, exacerbating this year’s inflation and compounding extant economic headwinds. This is understandable from a sentiment perspective and right in line with the fears driving this year’s bear market. Yet we also think it is quite out of step with oil supply and demand, not to mention how oil prices have behaved since spiking as Vladimir Putin invaded Ukraine.
Exhibit 1 shows global oil prices this year to date. As you will see, crude rose in the run-up to the invasion and spiked just afterward, reaching its year-to-date high on March 8. That, you might recall, is the day the UK announced its decision to ban Russian oil imports, heightening fears of a sudden supply crunch. But since summer, oil has declined steadily as it became apparent that Russian oil was finding buyers and global supply was resilient. Oil prices now sit right around pre-Ukraine war levels.
Exhibit 1: Brent Crude Oil in 2022
Stocks’ jarring week continued Thursday as the S&P 500 dropped -2.1%, closing a whisker below Tuesday’s low and bringing the bear market’s magnitude to -23.2%.[i] While that isn’t large by historical standards, retesting the lows after a summertime rally has understandably weighed on investors. Yet the mood seems to be one of frustrated resignation than outright panic, and we have a hunch why—and in a perhaps counterintuitive way, we think it argues for the recovery lying closer than many seem to expect now.
Last week, we looked at stock and bond mutual fund flows and considered the possibility that the panic selling known as capitulation was occurring more in bonds than stocks. That wasn’t a short-term market forecast, mind you, but an attempt to explore why investors’ behavior wasn’t quite typical for a late-stage stock bear market. This week’s bond market volatility seemingly underscores this hypothesis, judging from the sharp moves, reports of forced selling as pension funds scrambled to raise collateral, and the widespread presumption that much, much worse is in store for fixed income. That all suggests investors are taking their frustration out on bonds more than stocks right now.
Yet it isn’t just bonds that are down alongside stocks this year, and while it may be cold comfort, stocks are in the middle of the pack relative to other categories. Exhibit 1 shows year-to-date returns in US; World; Europe, Asia and Far East (EAFE); Emerging Markets and Japanese stocks (which we include due to Japan’s reputation as a safe haven), as well as two broad US bond indexes and the two flagship cryptocurrencies. Returns are as of Wednesday’s close, since Thursday’s tallies aren’t in across the board as we write, but one day won’t change the overall picture much. And that picture shows that if you are looking for an alternative to stocks, there really isn’t anywhere to go. Even the bond declines don’t quite capture the full picture, as fixed income’s grueling decline began before 2022. Supposedly defensive Japan is underperforming the US and global stocks. Crypto has crashed hardest of all.
Global stocks hit new lows this week as the bear market persists—extending a disappointing year. Naturally, many investors are frustrated, which is understandable. But frustration often gives rise to the urge to act—doing something, anything, can feel like taking back some control in an uncomfortable situation. However, this long into a bear market, such urges can easily be dangerously counterproductive. As challenging as this year has been, reacting to the past is arguably the biggest risk investors can take right now, in our view.
If the past two weeks feel like a bad case of déjà vu, your intuition isn’t far off base. This year has been a rollercoaster for global stocks. After a rocky spring, world stocks first crossed -20%—the threshold for bear markets (typically prolonged and fundamentally driven declines)—on June 13. Days later, on June 17, the MSCI World began a rebound. But after two months, the summertime rally faded and early this week, world stocks hit a new low—down -15.3% since August 16 and -25.1% since the January 4 peak.[i]
Exhibit 1: A Challenging Period for Global Stocks