Episode 11 – Thoughts on Recent Market Volatility

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Hello, everybody. Thank you for tuning in to Market Perspectives, a Mercer Advisors podcast where we provide a data-driven, common-sense perspective on the economy, on markets and on investing. I’m your host, Don Calcagni, Chief Investment Officer at Mercer Advisors.

Today I want to touch on recent market volatility. We’ve seen a pretty significant sell-off in global stocks over the past couple of months. Global stocks broadly are down somewhere around 8% since they reached their most recent high, which happened in late July, I think July 31. Just looking at the data here, it looks like that’s when global equity markets had hit a new high.

So down about 8% since then, but I think it’s important to step back and look at what stocks have done for the year. And global stocks are still up about 9% for the year. If you look at just US stocks, the S&P is up, depending on the day, somewhere between 12% and 13% for the year. And that’s after a pretty significant sell-off since the S&P reached a high in late July.

But nevertheless, this represents a fairly significant sell-off in stocks. And we’ll discuss just how significant here in a few moments. But I think it’s important to just comment on it so that we can understand perhaps what is driving the market. Why perhaps are we seeing global stocks and US stocks come down over the past couple of months.

And I think there’s a couple of obvious drivers, a few culprits that we could point to. And I think the first that I would highlight at the moment is rising oil prices. The OPEC cartel has ostensibly cut production. The Saudis have even gone a little bit further in cutting production. And I think that has spooked oil markets a little bit. So much so that we saw oil hit somewhere around $95 a barrel back on September 27.

And so I think that certainly was a concern and certainly a concern for consumers when we’re putting gas in our vehicles. And probably the most widely known price in the United States is the price for a gallon of gasoline. So certainly, I think that has been weighing on consumer sentiment. I think that has been weighing on markets, to some degree.

But I think it’s important to also highlight that oil has come down over the past several days, over the past week or so, I should say. And at the moment, it looks like oil is somewhere around $82 a barrel. So that’s a pretty significant decline in oil since the end of September. So a little bit of a silver lining there. Perhaps we’ll see ultimately where oil goes.

Certainly the UAW strike, certainly that is a big concern as it should be. All three automakers have been targeted by the UAW. Depending on the day, the market is either digesting that or perhaps looking past that. What I would say is that the supply chains that support automakers are certainly still significant, but I would argue they’re not nearly as significant from an economic perspective as they were certainly in years past.

So in terms of economic disruption, I was in a meeting with Moody’s Analytics where they had estimated it would be somewhere perhaps 10 basis points, maybe 20 basis points of GDP, depending on how long the UAW strike lasts. So I think that’s TBD.

At the moment, it looks like the UAW and the automakers have a long way to go before they can reach an agreement. They seem to be very far apart in their negotiations. So we’ll see what sort of impact the UAW strike ultimately has. My only comment is that from an economic perspective, the automotive industry as a percentage of US GDP is a lot less today than it was certainly several decades ago.

What else is also driving markets? I think first and foremost, the most powerful driver of markets, and I saved this for last on purpose, is rising interest rates. If you think about rising interest rates and the impact they have on assets, whether that be privately-held businesses or publicly-traded businesses, rising interest rates have a significant impact on all assets, especially stocks.

And that’s because stocks, from a pricing perspective, represent the present value of future expected cash flows back to investors. And those cash flows could be dividends for retired investors. Those cash flows could also be what we call retained earnings. And I’m not going to get into a boring accounting lecture. But the reality is stocks represent the present value of future expected profits that they earn from their operations.

And so when interest rates go up, what that means is that those future earnings that we have not earned yet, that we are going to earn 12 months from now or three years from now, or five or even 10 years from now, those earnings have to be discounted back to today because we don’t have them yet in our hands.

And so the way that we do that is we do that using interest rates. The interest rate is the discount rate that we use to reduce back from the future to the present the value of those future profits to investors. So at the moment, with rates rising significantly, that is putting downward pressure on equities.

And that’s not new. This happens all the time. When rates rise, bond prices go down. When interest rates rise, it’s harder for consumers to buy a home. Mortgage interest rates are rapidly approaching 8% for a 30-year mortgage. That is going to put downward pressure on home prices, in that it is going to push certain buyers out of the market that simply can’t afford an 8% 30-year mortgage.

So as rates rise, the big takeaway is that asset prices have to go down. The opposite is also true. And we’ve seen this over the past, let’s say 15 years, certainly since the global financial crisis when the Fed took rates down close to 0, and when the Fed pumped lots of new money, lots of liquidity into the financial system through their quantitative easing policy.

Nowadays, the Fed is implementing a quantitative tightening policy. They are trying to mop up all of that excess liquidity that they pumped into the financial system, let’s say, over the past 12 to 15 years.

So rising interest rates are having a significant impact on asset prices. I think the only thing that is surprising is that it’s taken this long to start to see asset prices start to incorporate to price in these higher interest rates. So let’s pivot for a moment here and ask ourselves, well, wait a minute, why are interest rates going up?

First and foremost, over the past 18 months, we know that the Federal Reserve has been raising interest rates. But honestly, the Fed did not raise interest rates at their September meeting, yet we’ve continued to see interest rates in the bond market go higher.

In fact, they’ve gone up about a full percentage point here fairly recently. So much so that the 30-year US Treasury bond is approaching about 5%. It’s somewhere around 4.8%, 4.9%,

depending on the day. That is a level that the 30-year Treasury bond has not seen since August of 2009. So interest rates have gone up. Again, the question is why.

Well, let’s begin with the federal debt. The federal debt is now somewhere in the mid $30 trillion range. So about $34, $35 trillion, that’s with a T. That is quite significant. That represents about 100% of our GDP.

Now that might sound high, but if we look at other countries, perhaps Japan, for example, you’ll see that their debt to GDP ratio is significantly higher. Depending on the country, it could be 200%, 250% of GDP. So we are certainly not the highest in terms of our debt to GDP ratio. But this is very high. The last time that it was this high in American history was during the Second World War. So certainly our debt to GDP ratio has increased quite dramatically.

The deficit is the amount of increase in the US debt in any given fiscal year. So the Congress has a fiscal year that runs from, I think, October 1 to September 30. That fiscal year, for 2023, that deficit is projected at $1.4 trillion.

That represents the shortfall between tax revenues, all those taxes that we pay–

Social Security taxes and income taxes and everything else. That represents the shortfall between taxes and the money that the government spends on everything from national defense to social programs like Social Security and Medicare to infrastructure–

road building and so on and so forth. So that represents the shortfall.

And that shortfall, despite what all the talking political heads would have us believe, it is very hard politically as citizens to agree on what we need to do to bring down that $1.4 trillion deficit. Anybody who tells you it’s easy isn’t paying attention. It is hard.

I think it’s very hard, especially when we consider that all of us know friends and family and loved ones who are on social welfare programs like Social Security, like Medicare, Medicaid. And all of us pay taxes and nobody likes paying taxes. So again, very, very hard, I would argue, to bridge that gap.

It doesn’t mean that we get off scot-free. It does not mean that we shouldn’t try. And certainly our political leaders who we sent to Washington, we are counting on them to find compromise, to find ways to do that. But that increasing debt, that deficit continues, in my view, to weigh on fixed income markets.

And if there comes a point in time where the bond market ever perceives that the US government will have a problem repaying its debts, that is naturally going to push interest rates higher. So that remains a significant concern.

Adding insult to injury here, there is clearly a significant amount of political dysfunction in Washington. And I think that dysfunction, to be candid, cuts across both sides of the aisle. And it makes it very hard to find compromise. And so I think that also continues to weigh on markets.

We did get a continuing resolution here for 45 days to avert a government shutdown. But a government shutdown is no laughing matter. You need to keep in mind that most federal government services would come to a screeching halt, including the provision of economic data that the US Federal Reserve relies on when making interest rate policies, when setting monetary policy.

So that is significant. The prospect of a federal government shutdown is nothing to be taken lightly. So I think that’s weighing on bond markets globally for US bonds. Let’s move on and look at some other drivers of what is potentially driving interest rates.

Inflation. Despite the fact that the Federal Reserve has raised interest rates over 500 basis points, much to my surprise, and I think to the surprise of most economists is that inflation has continued to run relatively high. And in fact, we’ve seen a slight uptick in inflation headline and core CPI in the August numbers.

We’ve also seen the jobs report just came out today and it was exceptionally strong. The Atlanta Fed’s GDPNow forecast, their estimate is that US GDP is growing at about 4.9%.

So I know on a prior podcast, we explored this question around whether or not the US was in recession or heading into recession. By any objective measure, when we look at the data right now, the US economy is not in recession.

If it were, arguably, we would start to see inflation tick down. And while inflation has come in, I think largely due to the stabilization of supply chains post-COVID, the reality remains is that inflation is still unacceptably too high for the Federal Reserve.

And just recently, Jerome Powell and a few other FOMC members have telegraphed quite explicitly, that they expect that we will have to raise interest rates–

we, being the Federal Reserve, will raise interest rates another quarter point, perhaps between now and the end of the year. And they have also communicated that the market should expect that interest rates will stay higher for longer.

And we are seeing that now in the futures markets for interest rate futures, now the market is expecting the Fed not to cut rates as aggressively next year as the market was previously expecting. And so we are still expecting interest rates to come down, perhaps about 1 percentage point between now and the end of next year. That is less than what the market was originally expecting.

So interest rates are rising. Inflation remains high. We have a high deficit in Washington. We also have some political challenges with respect to reaching compromise and ultimately bringing the two sides together to help solve some of these big financial challenges that our government is facing.

So I think those things are driving some increases in interest rates. We can debate which of those is having the most profound impact. I think that’s fundamentally unknowable. I think all of those factors together are pushing interest rates higher, which ultimately are working to push down equity prices and ultimately home prices and the price of all other assets throughout the US economy.

So I want to set a little bit more context as we approach the end of our time together. First is that market volatility is not new. Seeing a 7% or 8% sell-off in equities, to be quite candid, that’s normal. In fact, that’s actually below normal.

If you actually look at the intra-year volatility in the S&P 500 index over the past 35 years, it’s averaged about 14%, meaning that we have seen a 14% swing on average. This is the average–

a 14% swing in the value of the S&P 500 during any calendar year. What that means is 50% of the time, we have seen a swing greater than 14%, in half, let’s say of those 35 or so years.

So 14% is the average intra-year swing in the value of the S&P 500 index. We have seen only about an 8% sell-off since the end of July. That doesn’t mean that we’re going to see another 6% sell-off in equities. I only highlight that statistic to help normalize what we have seen in markets.

This is normal. If you talk to folks who’ve been long-term investors, talk to your friends, your family members who’ve been investors for several decades, this is pretty normal. There’s nothing here that we’ve seen over the past couple months that isn’t normal. And I wish it weren’t normal.

I mean, don’t get me wrong, I wish that markets were never volatile, but that’s just not realistic. That is certainly not realistic. So this is normal. This is normal.

There’s nothing here that I think should be unexpected.

Now, rather than fixating on the negative, I think it’s important to conclude and back up and look at the positive.

Valuations have come down. If you look at the valuation of S&P 500 stocks right now, there’s somewhere around 17 times earnings. They’ve come down from about 19 times earnings.

That’s a good thing. That’s a good thing for long-term investors, for those who are building wealth, for those who are still investing in their IRAs and their 401(k)s.

That’s a good thing. They’re now buying companies at lower prices.

And to be fair, company earnings right now are looking pretty good over the next 12 months. The estimate is for earnings to go up about 12% over the next 12 months. So again, for longer term investors, those who are building wealth, I think this is a good thing. It’s good to see valuations come in. It’s good to see markets balance at a price that makes sense. And so I think valuations coming in is a good thing.

Number 2, with respect to interest rates.

Interest rates have gone up significantly. This is a good thing for retirees. This is a good thing for investors focused on income. This is a good thing for those of us who are invested in broadly diversified portfolios that consist of both stocks and bonds. This is a good thing.

If you’re not earning at least 5.25% or 5.5% on high quality investment grade bonds, you should come talk to us.

I guess that’s my sales pitch for this week’s podcast. Treasuries–

a 12-month Treasury ladder–

we’re not talking anything that’s taking long-term risk, any duration risk. We’re not talking about anything that’s taking crazy credit risk. We’re talking a ladder that consists of 12-month US government bonds, you’re earning close to 5.5% That’s pretty darn good.

So when we look at our portfolios, we are earning significantly more interest now on the fixed Income part of those portfolios than was the case as recently as 12 to 18 months ago, we were earning pretty much close to 0 for those same types of bonds.

So I think for long-term investors, valuations coming in, hey, that’s a good thing. It helps to keep markets tempered. Tries to keep those animal spirits, that irrational exuberance that Alan Greenspan talked about in the late ’90s, for those of us who’ve been around that long, it keeps all of that in check. It keeps all of that in check.

We need valuations to come in. This is a sign, in my view, of a healthy operating market. When rates go up, asset prices come down. So again, that’s a good thing. These higher interest rates are a good thing for income investors and diversified investors. And we will end it there for today.

So that’s all for today. Thank you for listening. Should you have any questions, again, always, please feel free to reach out to your advisor here at Mercer Advisors. I’m Don Calcagni, and we look forward to seeing you next time. Thank you.