Stocks encountered another round of mild monthly losses in October, extending their streak of losses to three consecutive months. A more competitive picture in fixed income may have stripped away some demand for stocks as of late. When viewed from the lens of opportunity costs, every notch higher in fixed-income yields raises the performance bar for stocks to clear in the future. As a result, markets felt slightly unsettled last month as long-term US Treasury yields briefly touched 5% for the first time in over fifteen years. Of course, adjusting to a higher rate regime would have investment implications. But interestingly, it hasn’t impacted stock market returns nearly as negatively as many expected.
Even though stock markets didn’t finish higher last month, solid third-quarter earnings seemed to help support valuation. Large-cap earnings in the third quarter broadly exceeded investor expectations based on public reports. It’s a good thing, too, because good earnings from this year and from the past have likely immunized stocks against much of the past interest rate increases. Had the story played out differently and earnings stayed in a long cyclical decline, stock market price levels might look completely different than they do now.
To appreciate how rising long term rates have impacted financial prices, investors can evaluate proxies representing long-term US Treasury bond returns. A picture of those returns generally reveals double-digit losses over the past ten months due to rising long-term rates. In contrast, US and foreign large-cap stock returns are net positive over the same period, and mid- and small-cap returns are essentially flat year-to-date. The strength in stocks relative to fixed income this year is a testament to the excellent growth rates observed in stock market earnings. This makes it appear that interest rate changes are the primary source of recent negative returns.
In October, the US economy received more upbeat news. In the third quarter, the economy expanded by a 4.9% annualized rate based on first estimates, well above expectations! Moreover, last month’s GDP and labor reports showed unit productivity improved substantially. When the economy can raise and sell its production without a corresponding increase in input costs of similar magnitudes, it can represent an attractive investment environment. So far, the interest rate hikes instituted by monetary policy haven’t dented incomes or caused the unemployment rate to take off as many feared it would. Instead, recent labor reports reaffirmed that the labor market remains strong with robust hiring and low unemployment. In addition, approximately two jobs still exist for every unemployed person. Therefore, as long as the economy can remain this resilient, it will be difficult for an income problem to emerge.
Another moment of relief for the stock market was less aggressive forward guidance coming from many of the world’s leading central banks. Most importantly, the Federal Reserve Bank did not change its interest rate policy at the last open market committee, which recently convened. Furthermore, the European Central Bank, Bank of England, Bank of Canada, and Bank of Japan voted to keep their national rates steady ahead of the Federal Reserve’s decision. Investors view these events with renewed optimism that the restrictive rate cycle may be almost over. In addition, today’s elevated short-term rates allow room for future cuts when the globalized economy enters another recession.
Now that interest rates are higher than in the past, stocks have a new source of competition by way of fixed income securities. Remaining ahead of that competition requires more growth from corporate earnings. It is very difficult for investors to precisely predict how this will play out over the short term. Therefore, we feel strongly that the best solution is to diversify using appropriate investment vehicles. Diversification often results in certain portfolio parts working well, with others performing poorly. However, investors can successfully navigate these uncertain markets by including the proper asset classes, carefully crafting asset allocation decisions, and appropriately maintaining the portfolio over time.