Broker Check

The Cycle Continues

February 22, 2024

Sometimes capital markets seem like they’re running on a loop, with the same themes playing out over and over.  We’re in this type of cycle now.

  1. Inflation readings come in higher than expected, which causes interest rates to increase.
  2. Higher interest rates cause the equity market to sell off. Investors worry interest rates are too high and will eventually cause a recession.
  3. High interest rates and recession concerns attract more investor dollars to bonds. The extra demand for safe bonds lowers rates.
  4. Falling interest rates make equities look attractive again, which brings money into the equity market and fuels a rebound.
  5. Low interest rates and ensuing easier financial conditions increase the risk of higher inflation and the cycle restarts.

This has been the story for the past two years. The higher-than-expected inflation reading on February 13th suggested the end of the cycle that started in November of 2023.

The Equity Market

The return of the S&P 500 has been surprisingly, consistently, concentrated since the market bottomed out in the fall of 2022.  S&P 500 performance for 2023 was famously top heavy, with just seven names accounting for 61% of the overall return.  So far this year, the top four names in the S&P 500 (Nvidia, Microsoft, Facebook and Amazon) account for 61% of the index’s return through February 9th.

Although it’s frustrating to watch the market running in circles, the cycle does seem to be getting less volatile and is trending in the equity market’s favor.  Calendar 2022 illustrated the interest rate/ equity market/ bond market cycle precisely.  The S&P 500 fell 19%, and the Aggregate bond market (AGG) dropped nearly 14%.  The cycle played out twice in 2023. The S&P 500 returned 24% over the course of the year with one 10% correction, and the bond market returned 5.5% with a 6% correction.

Survival of the Most Financially Fit

The overarching concern of equity investors is the impact of interest rates on corporate profitability.  High interest rates are not much of a concern for firms with plenty of cash flow from operations; they don’t need to take out expensive debt to fund business operations and growth.  Firms that lack cash flow may need to borrow more, or at least maintain their current level of debt, to remain in business.  Higher debt expense can mean less revenue flowing to the bottom line and lower equity values (stock prices) for those firms.

To test the theory, we can look at the 50 firms in the S&P 500 that have the lowest quality balance sheets based on leverage, liquidity, solvency and profitability.  These are firms that have lots of debt, weak profits, and not much cash in the bank.  If the theory is correct, these companies should be especially sensitive to higher interest rates.  Companies on this list range from Boeing to Carnival Cruise Lines to Domino’s Pizza.  If investors really are worried about interest rates, this list of firms should be underperforming the overall index when interest rate concerns flare up.

Unsurprisingly, that’s exactly what we found.  The 50 lowest quality firms in the S&P 500 are at the lowest relative value to the overall market since the depth of COVID in April of 2020.  Balance sheet quality is not the only factor at play here.  Idiosyncratic factors, such as neglecting to properly install door plugs on a jetliner, can influence stock price.  Generally though, investor concern about the impact of higher interest rates on stock prices appears to be demonstrably valid.  Further illustrating the point, the 50 firms with the highest quality balance sheets have the highest relative valuation to the S&P 500 over the past five years.  Investors are rewarding the strong and punishing the weak.

Returning to Boeing for a moment.  The company has $13 billion of bonds maturing between now and 2026.  Some of those bonds have coupons of less than 3%.  When Boeing goes to market to refinance, they’ll likely need to pay ~5.2%, which is the going rate for BBB-rated firms like Boeing for five-year debt.  This situation will increase debt service costs and may cut into overall corporate profitability. 

Many firms have some version of this scenario, but it is more acute for small firms and probably a big reason why the US Small Cap asset class remains ~20% below the peak achieved in late 2021.

This sensitivity to interest rates squares nicely with other datapoints.  For one, it helps explain why market leadership is so concentrated.  The top 5 firms in the S&P 500 are among the few companies that have both earnings growth (thank you, AI) and high-quality balance sheets.  It also explains why every time interest rates fall, the other 495 companies in the S&P 500 show signs of life; investors are pouncing on the possibility that lower interest rates will allow these firms to be more profitable going forward.

What’s Next for Investors?

Until interest rates fall meaningfully and durably, some version of this “chasing your tail cycle” will persist.  There will probably be enthusiasm at every inflation report illustrating that the trend lower continues, increasing the odds that the Fed will begin cutting rates sooner than later.  And there will probably be consternation if inflation ticks up, as the January report illustrated, likely postponing the first Fed rate cut. 

On the bright side, inflation peaked at 9.1% in the summer of 2021, and the most recent reading was 3.1%.  Even if there are speedbumps along the way, the trend is positive.  Maybe the “higher interest rates for longer” scenario won’t materialize.  Perhaps inflation and interest rates will fall on their own before the issue is pressed.  No one knows for sure, which again, is why we’re locked into this cycle of speculative optimism followed by varying degrees of market corrections.  In a way, it’s a game of chicken between investors’ hopes and dreams for better days and the Fed’s desire to crush inflation with high interest rates.

Attempting to time this market with higher frequency, tactical investing decisions would be completely foolish.  The better approach, and the one that we’re using, is to simply rebalance portfolios at the extreme points, when compelling buying opportunities materialize. That, combined with an allocation that leans away from smaller, less profitable companies and minimizes interest rate risk has been a winning combination.  As always, patience is a virtue.


Closing Comments

Punxsutawney Phil predicted the early arrival of spring.  While we generally don’t go in for this type of speculation, we are certainly on board. 

If you have questions about anything contained in this narrative, or anything else, please contact your PIM Financial Advisor. 

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