THE MACRO MINUTE

The recent move in interest rates has had far reaching, and potentially, more costly impacts on the economy and markets than we can presently know. Unfortunately, the dominoes that will fall because of this higher level in risk free interest rates are manifest.

Until recently, the market had become overzealous in its expectations for rate cuts. Since the July peak the market then had to recalibrate expectations to ‘higher for longer from expectations for rate cuts. As a result, many securities that are more rate sensitive, due to the embedded duration e.g., long term bonds and growth stocks, have been hardest hit in the market correction.

There appears to be two camps in the debate about the longer-term trajectory for rates: 1) longer term inflation is structurally higher at around 3% and will thus require a higher floor to the Fed funds rate; and 2) interest rates are likely only in a temporary phase rather than a return to “normalization” –meaning the rate term structure from the late 20th century.

The case for higher structural inflation is apt, but it’s unwise to dismiss the fact that globally, and over a *very long period of time, the trend in real rates has been perpetually lower since the Black Plague. The rational behind the long-term trend is relatively simple: all else equal if society is in survival mode there will be a higher cost of capital. Whereas a society with surplus has a low cost of capital.

The debate is really around a cyclical versus secular outlook. Said another way some members of a society can temporarily reduce consumption and save. Where the risks of permanent impairment of capital are not catastrophic these people can provide resources to clever people, -usually engineers. When executed well those clever people deliver clever ideas and produce future surplus, rinse and repeat. We can easily see why the very long-term trend in rates would be negative. It’s never a good idea to short either human ingenuity or our ability to adapt and survive. We are like a virus with shoes.

The primary risk will be in rising bankruptcies as a result of the significant increase in risk free rates, a fall in credit conditions, economic activity, and hourly earnings. This sits as the crux of the debate for a “soft” vs. “hard” landing. Is the Fed so focused on employment that rising corporate bankruptcy is ignored until refinancing risk drives credit spreads significantly higher, and potentially creating a material default cycle? If this cycle were to play out in this way that would force policy makers’ hands to cut -and possibly before a 2% inflation target is reached. That is bad news on the structural inflation front. *This is not meant to be alarmist, but it is meant to inform about the material risk that exists, unpriced, in the credit market. Moreover, no one appears to be paying attention. Are strategists, economists, and the street being fooled by money illusion and the perceived strength in the labor market… a well-known lagging indicator?

• Over the month, markets had to reset to higher for longer expectations for interest rates. Small caps, where companies are more reliant on external financing, were hardest hit.

• Energy and international stocks were also hard hit by the reset in the dollar, as currencies are fundamentally driven by interest rate differentials.

• On a trailing 3-month basis energy, communications, and healthcare dominate relative returns, where as materials, consumer discretionary, and real estate are the relative return laggards.

• Commodities are the bright spot in markets on one- and three-month trail returns. Notably, sugar, natural gas, and gold were top performers.

• The forward risk premium for US stocks is only 3.4%, compared to a 2Y UST at 5.06%; developed and emerging international appear more attractive.