Headwinds

By Paul Broughton, Portfolio Manager

In mid-July, the Goldman Sachs Financial Conditions Index hit a 2023 year-to-date low (i.e., loose) and a few days later, we saw the S&P 500 reach it’s 2023 high of about 4,589.  When financial conditions are loose, it typifies a bullish environment for equities and vice versa.  Then for the next three months, financial conditions tightened, as rates rose sharply, leading the GS index to move higher, and equities sold off through late October, down a painful 10%.  Some of this was seasonal, September and October are known to be historically weak, but most of the sell-off in equities was likely due to rates moving higher across the curve, especially for longer dated bonds.  For context, the Goldman Sachs Financial Conditions Index is a weighted average of short-term interest rates, long-term interest rates, the trade-weighted dollar, an index of credit spreads, and the ratio of equity prices to the 10-year average of earnings per share.

The 10yr Treasury bond was at 3.96% at the end of July, but it rose by over 100 basis points over the next three months— a remarkable move higher in a very short amount of time – reaching a sixteen year high of 4.99% on a closing basis on October 19th.  Fed Governor Christopher Waller noted that “since the end of July, this thing has gone way up, almost a full percentage point.  In central bank terms, in financial markets, that’s an earthquake.”  But in a quick partial reversal since that 4.99% level on Oct 19th, the benchmark 10yr has eased back to 4.63%.  This move lower was sufficient to engender a relief rally in equities of nearly 7.3% largely due merely to the 10yr not going up further.  Broadly, the pressure from higher rates across the curve inflicted a lot of damage to equities due to the higher discount rate applied to stock valuations.  Similarly, the 30yr mortgage rate rose by almost 100 basis points and this further exacerbated the housing situation since it encourages existing homeowners to stay in their homes and forgo trading up to retain a low mortgage rate rather than financing a purchase at something around 8.00%.

With the significant move higher in rates this year, it’s worth examining the health of the underlying equity market.  The S&P 500 is up a respectable 16.6% YTD, however most of this return is attributable to seven mega cap stocks.  Excluding the “Magnificent Seven,” the S&P 493 is about flat for the year, about the same as the S&P 500 equal-weight’s 1.2% return.  In other words, this market has been very narrowly focused on those seven names and their multiples reflect this and then some.  The seven collectively trade at an average P/E of about 41x compared to the S&P 500’s 18.5x and the S&P equal-weight’s 14.9x.  As well, small- and midcap stocks are about flat for the year.  So, outside of the magnificent seven the broad market is essentially treading water as higher interest rates continue to impact returns.

Investors need to recognize that these companies will need to at least maintain their growth rates to keep their current multiples and, for companies without sufficient economies of scale, this gets incrementally harder as they get larger and larger over time (trees do not grow to the sky forever).  As well, the market leadership that they’ve demonstrated over the last several years could wane if the network effects behind those scale economies peter out.  Looking beyond the magnificent seven reveals opportunities for investors to own high quality companies that aren’t as nearly loved and well known, namely many candidates among the S&P 493.

Pivoting back to rates, the Fed may be on pause as they wait for inflation to moderate in the next few months.  Who knows?  But they may be forced to raise further just as the Canadian and Australian central banks did recently after being on pause for several months.  The fact that a further rate hike (or hikes) may be necessary and the very clear communication from the Fed that rates will likely be “higher for longer” should give investors insight that rates will continue to weigh on equity valuations and returns over the next couple of quarters at least.  But if investors seek value in equities, it is available in many of the S&P 493.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.