The price of money

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Executive snapshot

The verdict

Our regime call is unchanged and constructive, and the book carries forward. September was a real-rate shock rather than a growth scare. The Fed raised rates a quarter point on September 16, and by month-end the 10-year Treasury yield had its highest close since 2002. Almost all of that rise came from real yields, the return investors demand after inflation, while expected inflation barely moved. That is the price of money going up, and it raises the bar every asset has to clear. Growth has not flinched. The Weekly Economic Index has averaged 2.7% this year and the current-quarter nowcast is 3.7%. So we stay slightly overweight equities, led by US large caps, because higher rates change what we pay for earnings, not whether the earnings arrive. We stay underweight fixed income without extending duration, and we keep the real-asset tilt. Two readings have moved against us. Stocks now yield slightly less than Treasuries, with the equity risk premium at -0.07 percentage points, and earnings revisions have slipped just below zero. High-yield spreads have also started to widen, though the broad financial-conditions gauges have not followed. We are watching credit closely.

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Portfolio stance

• Equities: Slight Overweight. Earnings are still arriving, so we stay overweight, led by US large caps. Higher real yields change what we pay for those earnings, and that is the risk we are watching.
• Fixed Income: Underweight. We hold fewer bonds than a standard 60/40 and keep duration modestly short. We are not extending while rate volatility is high and inflation sits above target.
• Alternatives: Slight Overweight. Real assets hedge a Fed that still has work to do. We hold a broad commodity basket and gold, and accept that gold gives some back when real yields rise.

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Core driver

Real yields did the lifting. Between the end of August and the end of September, the 10-year Treasury yield rose 0.54 percentage points. The 10-year real yield, the yield on inflation-protected Treasuries, rose 0.49 points of that, and the breakeven inflation rate, the market's estimate of future inflation, rose only 0.05. The pattern was already clear by September 24, when the real yield was up 0.41 points against 0.43 for the nominal yield, and it kept going into month-end. Our read is that investors are asking to be paid more in real terms for lending money, rather than pricing more inflation. That read is an inference from how the move split, and we cannot measure the cause directly.

The rise was global in direction but mainly a US story in size. By September 24, 10-year inflation-linked yields were higher this year in every major market we track. They were up about 1 percentage point in the US, against 0.1 to 0.7 points in Canada, the UK, Germany, Japan and France, where more of the rise in nominal yields came from higher inflation expectations.

A higher real yield is a higher discount rate. It lowers what a future dollar of earnings or coupons is worth today, so it touches every sleeve at once. Federal Reserve research attributes the 2022 equity drawdown mainly to rising real yields, and finds that the 2008 and 2020 sell-offs came from lower expected earnings and a higher equity risk premium instead. The lesson we take is narrow: rising real yields are a headwind while they rise, but on their own they do not stop the earnings. Here is what that means for each part of the book.

Equities. We stay slightly overweight, with US large caps overweight. The S&P 500 slipped in September and is up 11.8% this year, so the market has absorbed the move so far. The cost shows up in valuation. At 19.08 times forward earnings, stocks now yield slightly less than a 10-year Treasury, so there is no valuation cushion left. That caps how hard we lean, and it is why the tilt stays slight. Small caps are the most rate-sensitive corner of the market and the place rate pressure would show first. We hold no tilt toward them and are watching them closely.

Fixed income. The underweight did its job. Long-dated Treasuries fell 5.7% in September and investment-grade corporate bonds fell 3.8%. We hold fewer bonds than a standard 60/40. Taken on its own, our bond sleeve has a duration, a measure of sensitivity to rates, of about 4.9 years, against about 5.5 years for the bond sleeve of a standard 60/40, mostly because of our high-yield, convertible and short inflation-protected bond funds. By our estimate the portfolio is about 30% less sensitive to rates than a 60/40, and most of that comes from holding fewer bonds rather than shorter ones. The high-yield underweight, set because spreads were too tight to pay for the risk, protected us when those spreads widened late in the month.

Real assets. The month was mixed. Commodities worked: Brent crude rose 14.4% and a broad commodity fund rose 3.3%. Gold fell 6.6% as real yields and the dollar rose together, which is the cost of holding a hedge against fiscal risk when the return on cash goes up. Inflation-protected Treasuries fell 2.6%. That is why, while rates keep grinding higher, we prefer a commodity basket to them. We keep both legs of the sleeve.

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Macro thoughts

Growth: above trend, and not yet touched by higher rates

Growth has not slowed. The Weekly Economic Index has averaged 2.7% this year, against a trend near 2%, and the Atlanta Fed's current-quarter nowcast is 3.7%. Unemployment is 4.1%, low and steady. Nothing in the output data argues for less equity risk.

The question is what higher rates do next. Smaller companies and borrowers who depend on short-term financing feel the price of money first. We will judge whether that is happening through jobless claims, the unemployment rate and earnings revisions together, not through any single monthly print, including the September jobs report on October 2.

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Inflation: the Fed's gauge is flat near 3% while oil lifts the headline

Headline CPI was 3.4% in August, and the nowcasts put it at 3.6% for September and October as oil rose. Core PCE, the gauge the Fed acts on, was 3.0% in August and is nowcast at 3.0% and then 3.1%. Both sit well above the 2% target.

Core PCE needs a word on revisions. In mid-September we cited July core PCE at 3.3%, as first published, and a path rising toward 3.5%. The government's annual revision on September 30 lowered July to about 3.0%, and August came in at 3.0% as well, with headline PCE at 3.4%. So on current data the Fed's gauge is flat near 3%. That softens one of our reasons for keeping duration short. It does not remove the case: inflation is still a full point above target, the headline is rising, and the Fed hiked in September to get back to target sooner.

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Financial conditions and the Fed: real yields tightened, credit only at the edge

Monetary policy tightened again in September. The Fed raised rates a quarter point on September 16 and said the move would support a timelier return to their 2% goal. Futures now price 3.60 quarter-point hikes through December 2027, up from 3.14 in mid-September. For the October 28 meeting, futures settled on September 30 implied roughly a 38% chance of another hike.

This time the tightening reached market rates, through real yields, more than it reached credit. The national financial conditions index is -0.55, essentially unchanged, and the St. Louis Fed stress index is -0.81, still calm. Investment-grade spreads moved only from 81 to 84 basis points. High yield is the exception. In mid-September, high-yield spreads were 265 basis points. By September 30 they were 312, with most of the widening in the last week of the month. That is the signal we said would matter, and it has started at the riskiest edge of the market. It has not yet spread to investment grade or to the broad gauges.

The yield curve told a similar story. By September 24 the 2-year yield had risen about 0.53 points in the month against 0.43 for the 10-year, a bear flattening in which short-term yields rose faster than long-term ones, with nearly all of the 10-year's move in real yields. In the final week the long end caught up, and the gap between 2-year and 10-year yields ended September where it began, at 0.41 points. We treat the curve's shape as secondary. The research ties equity damage to the level of real yields, and that level is what we watch.

Japan is a channel to watch rather than a driver. The yen slipped in the second half of September, from about 154 per dollar in mid-month to about 158 by September 24, even after the Bank of Japan raised rates again. Tokyo spent roughly 27 trillion yen supporting its currency across April, May, July and August, and has said it would not hesitate to step in again. Japan's reported Treasury holdings fell about $135 billion between February and July. Those figures include private investors and cannot show official selling, and Tokyo has said it plans to use the Fed's repo facility rather than sell outright. Japan reported no intervention between August 27 and September 28. September's rise in yields was also led by shorter maturities, while the gap between 10-year and 30-year yields narrowed. Heavy Japanese selling of long bonds would have pushed that gap wider.

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Earnings and valuation: the cushion over bonds is gone

The S&P 500 trades at 19.08 times forward earnings, a little below its 10-year average of about 20 times, so the multiple itself is not stretched. The pressure comes from the other side of the comparison. With the 10-year Treasury yield at its highest since 2002, the equity risk premium, what owning stocks pays over a 10-year Treasury, has turned negative at -0.07 percentage points, from 0.23 in mid-September.

Earnings revisions are the reading to watch. The revision index slipped to -0.06 from 0.51 in mid-September, so analysts are now cutting estimates slightly more often than raising them. One reading is not a trend, and the fundamentals behind the overweight have been robust. Even so, this is the first fundamental reading to move against us, and it is the one we would expect to turn first if higher rates were starting to bite.

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Geopolitics: Hormuz still disrupted, oil back in the inflation story

The Strait of Hormuz has not normalized. Arrivals are running at about 3 ships a day on a 7-day average, down from 5 in mid-September and against roughly 60 in normal times, and the market-implied odds of normalization by year-end are 20%. Brent crude rose 14.4% in September.

Energy is the most direct route from geopolitics into headline inflation, and the headline nowcasts are already rising. A Fed that hiked to reach target sooner has little room to look through an oil shock. That is why we hold a broad commodity basket. It carries the energy leg without a bet on any single commodity.

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The Savvy Macro Dashboard

Summary

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Data

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Question of the month

"Will higher real rates end the party for stocks?"

Not on their own, and not yet. Higher real yields lower what future earnings are worth today, which is why stock valuations come under pressure while yields rise. That is what happened in 2022. A higher discount rate and a broken earnings stream are different problems, though. Growth is above trend and earnings are still arriving, so a hike or two changes what we pay for those earnings without stopping them. What would end the party is credit. If high-yield spreads keep widening and the stress spreads into investment-grade bonds and the broad financial-conditions gauges, tighter money would be reaching companies' ability to borrow. Our response to that is set in advance: reduce equity risk, upgrade quality, extend duration and take the commodity tilt back to neutral, together. High yield has started to move. The rest has not.

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"Bond yields are the highest in decades. Why not buy more bonds now?"

Because the yield is only part of what a bond returns. The rest is what happens to its price, and with the 10-year yield rising more than half a point in a single month and the Fed still tightening, we are not paid enough to take more of that risk. A 10-year yield of 5.29% is attractive income, and we own bonds for exactly that, in a sleeve that runs a little shorter than the market. What we will not do yet is extend duration. The case for extending is strongest when tighter money starts to slow the economy or crack credit, because that is when yields have room to fall. If credit keeps deteriorating, extending duration is part of the plan we have already set out.

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Savvy Total Portfolios: tactical asset allocation positioning

No changes to positioning this month.

Last change: exited Consumer Discretionary (XLY) in late August. See the September issue.

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Asset class views

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Sector views

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Risks we're watching

1. Real yields keep climbing.

The 10-year Treasury yield ended September at 5.29% and the 10-year real yield at 2.93%. Another leg up would keep pressing on equity valuations. In our judgment, at these levels bonds and stocks can start to fall together, which weakens the cushion bonds normally provide. Our fixed income underweight and modestly short duration are the hedge, and we would not add duration into a rising real yield.

2. Credit stress spreads beyond high yield.

This is the risk we named last month, before credit had moved. High-yield spreads have since widened from 265 to 312 basis points, while investment-grade spreads, at 84, and the broad financial-conditions gauges have barely moved. If the widening spreads, we would reduce equity risk, upgrade quality, extend duration and take the commodity tilt to neutral. High yield alone is not yet enough.

3. Japan defends the yen again.

Tokyo has said it would not hesitate to intervene, and the yen slipped in the second half of September. A fresh round of intervention funded by selling Treasuries would add pressure at the long end of the curve. We see no evidence of that so far, and Tokyo has signaled it would use the Fed's repo facility first. We treat it as a contingent risk for long bonds and one more reason not to extend duration.

4. Inflation forces the Fed's hand in October.

Headline CPI nowcasts sit at 3.6% and oil rose sharply in September. The Fed meets on October 28, the day before September's PCE report, so the September CPI report on October 14 is the last major inflation print before the decision. A second hike would push the priced path and real yields higher again. Our real-asset tilt is the hedge.

5. Earnings revisions roll over.

The revision index has slipped just below zero. If analysts keep cutting estimates while real yields stay high, both halves of the equity case weaken at once: what we pay and what we earn. That combination, more than either alone, would lead us to cut the equity overweight. We would not act on a single reading.

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Closing thoughts

September raised the price of money through real yields rather than through inflation fears or a weaker economy. Our book was built for a Fed with work left to do: underweight bonds, modestly short duration, light on high yield and holding real assets. Most of that positioning helped this month, with gold the exception, and we are not changing it. We keep the equity overweight because growth and earnings have held up, and we accept that the margin for error is thinner than it was.

October has a crowded calendar. The September jobs report lands on October 2, the CPI report on October 14, the Fed decision on October 28 and September PCE the next morning. We will not reposition around any one of those prints. Credit is the signal that would move us.

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