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The Usual Suspects

October 2023

Most of us under the age of 50 have lived our adult lives without facing substantial inflation or high interest rates. Sure, we have heard horror stories from our parents or grandparents, but we have never witnessed them firsthand. Moreover, if you have spent your career with CNBC or Bloomberg running in the background, then you have heard countless reassurances from economists and market strategists that you would likely never have to face elevated inflation and interest rates because the structure of the U.S. economy is different now.

Wouldn’t that be nice — no more inflation or expensive borrowing costs? Sadly, it seems a bit whimsical to me and reminds me of a great line from a movie, “The greatest trick the devil ever pulled was convincing the world he didn’t exist.” Those were the famous words of Verbal Kint describing the elusive and ruthless crime lord Keyser Söze, whose status reached such a mythical level that neither law enforcement nor criminals knew whether he was an actual person or a folktale. You see, Mr. Söze would purportedly surface occasionally for a big score or to extract vengeance on his enemies, then disappear for years at a time. His true identity was never revealed, leaving his victims to wonder if it was him or his associates. The film was The Usual Suspects and the year was 1995.

Four years prior, in December 1991, core inflation (inflation that excludes food and energy) measured 4.4% on an annual basis. The following 30-year period from 1992 – 2021 never saw core inflation rise more than 4% on an annual basis. In fact, it only exceeded 3% for a matter of months — a remarkable statistic given that: 1) inflation is measured every month, translating to about 360 measurement periods; and 2) none of the wars, economic booms, busts or stimulus packages along the way created 4% inflation, not even for 1 of those 360 periods!

Enter the Villians

Along came the global pandemic, and of course, everything changed. Inflation — a usual suspect in the causation of economic problems — suddenly resurfaced after decades in hiding. Historic stimulus programs injected more dollars into the pockets of individuals and businesses. Due to pandemic-related supply constraints, those dollars chased relatively fewer goods and services, causing prices to rise significantly. Core inflation quickly jumped from a 1.5% to 6.5% annual rate as everything from clothing to transportation to shelter became more expensive.

The Federal Reserve, in an effort to achieve its mandate of price stability, began raising interest rates from record-low levels in March 2022. Eighteen months and eleven interest rate hikes later, another usual suspect of economic problems was on the scene. (Enter high interest rates.) With the Fed Funds rate now at 5.5% — a robust 5% higher than the beginning of 2022 — high interest rates appear to have quickly changed the mindsets of both individuals and businesses.

Not A Folktale

Gone are the days of carefree credit. The average interest rate on a new car loan is 7.4%, while a loan for a used car will cost you 11.2%.1 The market for existing homes is effectively frozen, as sellers refuse to give up their existing mortgages. A report by Black Knight Inc. estimated that the average interest rate paid on outstanding U.S. primary residence mortgage debt was 3.94%.2 Given that the current average rate on a fixed rate 30-year mortgage is 7.75%, it is not surprising that people are staying put. According to Redfin, just 1% of existing homes in the U.S. traded hands in the first half of 2023 — the lowest share on record.3 The “stay-put” strategy may work well for now to hide from higher borrowing costs, but one wonders what may happen if a higher rate regime persists for a longer period of time, or an economic dislocation forces many to move.

Businesses are trying to navigate around inflation and high interest rates as well. Going public, mergers, acquisitions and recapitalizations are not as easy as they used to be. Nowadays, you hear many CEOs say “next quarter” (and hope their shareholders don’t notice they have repeated that line for the last eight quarters). Many of the retailers we follow report that their luxury items are sitting on shelves while Americans “trade down” to lower-cost necessities, translating to slower revenue growth as well as lower profit margins. Further, many companies are struggling with the rise of theft — in transit, at the loading docks and in stores (from Lululemon to Dollar Tree). The current financing environment further complicates this challenging businesses backdrop. While homeowners may secure a 30-year mortgage to finance their lifestyle, companies generally rely on shorter-term debt to fund operations, taking 3- to 7-year loans with a floating interest rate to fund operations. Hence, the business community’s ability to delay the pain of higher rates is much less than that of many homeowners.

Investors are adjusting as well. Five-year treasury bonds have averaged a yield of 1.9% over the past decade. Today, that same bond yields 4.6%. Meanwhile, the S&P 500’s earnings yield (the earnings of the index divided by the price, or put another way, what you get “paid” in earnings) has averaged 5.4% over the last ten years, while today it pays 5.1%. You can see the dilemma here for stocks. Typically, one would expect the earnings yield of stocks to exceed the yield offered by the safety of U.S. government bonds. As those two yields converge, it is logical for some investors to shift money from stocks to bonds. To further muddy the waters, a money market fund pays around 5.25%. While that rate floats daily, as opposed to the one offered by bonds which can be “locked in,” money market funds are still an attractive alternative to those concerned about investing in risky assets.

Underestimated Adversary

How long can we expect this environment to persist? That depends upon who you ask. Some felt that this jump in rates and inflation would be temporary — a quick blip in the chart history of time. Even Jerome Powell, the chair of the Federal Reserve, stated in March 2021, “It’ll turn out to be a one-time sort of bulge in prices, but it won’t change inflation going forward.”4 Yet the months have continued to pass by, and inflation has proven stickier than anticipated. Recent moves in the bond market indicate that even those who do not believe inflation will last for years may start to worry. That’s similar to Dean Keaton’s logic, another one of The Usual Suspects, when asked why he feared the legend of Keyser Söze, “I don’t believe in God, but I’m afraid of him.”

Despite these challenges, we hear far fewer reservations about stocks now relative to the beginning of this year. Perhaps year-to-date returns are a big reason for that difference, but that’s just speculation. Not wanting to sound too gloomy, there is also plenty to like about this climate. In the 16-year history of Hamilton Point, we have never been able to invest clients’ bond portfolios at such attractive interest rates. Further, elevated inflation and higher interest rates may remind folks that principles such as saving and prudent spending are always good protections against whatever market devils may be lurking.

All market data is sourced from Bloomberg unless otherwise noted. 1. 2. 3. 4.


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