It seems that we’ve passed an inflection point. Interest rates have peaked for the time being. Stocks and bonds are slowly recovering from their lows last fall. The S&P 500 ended the third quarter at 3,585 and today is a bit over 4,100. That’s a gain of more than fifteen percent over the last four months. The typical portfolio of 60% stocks/40% bonds is also up more than ten percent.
Fixed income is recovering almost in lockstep with equities. The interest rate cycle is driving the performance of almost all asset classes. I use the two-year treasury rate as an indication of where the market thinks interest rates will peak. After peaking at 4.7% two months ago, the two-year treasury has fallen back to 4.2%. Rates are pulling back in response to the latest inflation reports which suggest that we are past the peak in inflation. The following chart shows various monthly inflation measures annualized. This shows that inflation has turned negative over the last couple of months. Over the past six months, inflation is in line with the Federal Reserve target of 2%.
The market is beginning to expect that the Federal Reserve will only raise rates by a quarter point at the next meeting. The question will then shift to whether the Fed is done raising interest rates. It’s very hard to know when and at what pace interest rates will come down, but I think we have seen the top in interest rates. Five percent short-term rates are most likely the ceiling.
If we’ve seen the peak in interest rates, then we’ve also most likely seen the trough for valuations. At the peak in August of 2020 the S&P 500 was trading at 24 times earnings. Valuations fell to 15 times earnings last fall. They’ve since recovered to 18 times earnings, which is about the average over the last five years. We’ll have to see interest rates fall more substantially before we should expect any further increase in valuations. The market is pricing in $220 earnings for 2023. As we move through the year, the market will look past the period of low earnings growth and begin to look forward to 2024.
The further we look into the future the harder it is to have confidence in our forecasts, but we must start somewhere. Investors expect earnings to grow to $250 in 2024. If we assume the midpoint of the valuation range for the last five years, we get a year-end price target of 4,500 for the S&P 500. This equates to a 12.5% gain and a total return of almost 15% including dividends.
There are a wide range of forecasts among investors. Focusing on the midpoint may be somewhat arbitrary. The midpoint could be the least likely outcome as much will depend on whether we avoid a recession. If we get a “soft landing” that consists of disinflation but no recession, earnings estimates are probably too low. We may be making this more complicated than it needs to be. Since 1950, there have been nineteen years with negative returns for the S&P 500. The return in the year following these negative years has exceeded 20% ten times out of nineteen.
Perhaps the best historical analogue to the current investment environment is 1982. The Federal Reserve aggressively targeted inflation which led to a 27% sell-off for the market. At soon as the fed “pivoted” to a less aggressive policy, stocks rebounded. Stocks fully recovered from the two-year bear market within four months.
It’s important to remember that the primary trend of the markets is higher. Over the very long-term, stocks have generated returns of about 9%. The path of how we have moved forward is the path of history itself. Much progress is the result of trial and error. Eventually we learn from our mistakes.
Most of the time, I think the impact of politics on the markets is overrated. Over my career of almost thirty years now, I can think of two periods where politicians really bothered the markets; 2008-9, when congress failed to pass a bill that would guarantee the largest U.S. banks, and again in 2011 when congress refused to raise the debt ceiling. Markets dropped almost 20% in five days before congress acted, allowing the markets to quickly recover.
The debt ceiling is the legal limit on the total amount of federal debt the government can accrue. Since the end of World War II, Congress and the President have modified the debt ceiling more than 100 times, according to the Congressional Research Service. During the 1980s, the debt ceiling was increased from less than $1 trillion to nearly $3 trillion. Over the course of the 1990s, it was doubled to nearly $6 trillion, and in the 2000s it was again doubled to over $12 trillion.
The debt ceiling increase enacted in late 2021 is expected to allow the federal government to pay its obligations until at least June. Given that congress is politically divided, negotiations over how to address the debt ceiling in 2023 could continue for months.
Capital markets punish politicians when politicians create obstacles to market stability. The question is how sensitive or vulnerable the politicians are. I’m not optimistic that there will be an easy agreement between the parties responsible for negotiating the debt ceiling resolution, but I’m not sure that anyone else is either. In markets it’s the things you don’t see that tend to cause the most havoc, so perhaps the worst-case scenario is already discounted.
I don’t think there is a large enough constituency in the Republican party to prevent an eventual agreement on raising the debt ceiling. The history of presidential elections after debt ceiling fights has not been good for Republicans. Former Bush speechwriter Marc Thiessen writes in the Washington Post:
In 1995, after Republicans took control of the House with a much larger majority than they have today, Speaker Newt Gingrich threatened not to raise the debt limit unless President Bill Clinton agreed to $245 billion in tax cuts, restraints on new Medicare and Medicaid spending, and a balanced budget within seven years. Republicans didn’t get most of their demands, and they paid for their brinkmanship the following year, when Clinton won reelection in a 379-159 electoral college landslide.
In 2011, Republicans again picked a fight over the debt ceiling. This time, it was the Democrats who flinched. President Barack Obama agreed to the Budget Control Act of 2011, which used a blunt instrument — sequestration — to mandate automatic across-the-board spending cuts if Republicans and Democrats could not agree on targeted reductions. They did not, with the result that Obama’s discretionary spending was restrained — but at the cost of massive defense cuts that have hurt our ability to compete with and deter a rising Communist China. In the end, Obama had the last laugh. He won reelection the next year in another electoral college landslide, 332-206.