Rates Take Center Stage | ETF Trends

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The View from 30,000 feet

Macro events last week dominated market action. Although fresh readings from the labor markets provided some sparks for speculation around Fed action and earnings report from Apple and Amazon moved individual names, the real story of last week took place in the bond market where the 10-Year Treasury went from a weekly low of 3.92 to a high of 4.20, threatening to breakout to new cycle highs before backing off again at the end of the week. Central banks were also in the spotlight with Japan forced to defend their currency in response to market pressures from the previous week’s dovish actions, the South American countries officially embarked on an easing cycle, and senior officials from both the Fed and ECB came out openly with statements that they no longer supported rate hikes.

  • Labor market reports shows an encouraging trend but falls short the Fed’s threshold for comfort
  • Bond market sniffing out higher yields all week got boost from Fitch with a downgrade of US debt
  • Private markets showing signs of stress from rising rates and tighter lending standards
  • The most Frequently Asked Question from clients this week: How expensive are the Magnificent 7?


Labor market reports shows an encouraging trend but falls short the Fed’s threshold for comfort

  • OLTS
    • JOLTS reported 9582k, slightly below expectations with prior month revised 208k lower
    • Quits Rate drops to 2.4%, considered in line with pre-pandemic trend
    • Hire Rate drops to 3.8%, now slightly below pre-pandemic trend
  • Payroll Report
    • Nonfarm Payrolls 187k, below expectations of 200k, with prior month revised 16k lower
    • Private Payrolls 172k, below expectation of 180k, with prior month revised 21k lower
    • Unemployment 3.5%, below expectation of 3.6%
    • Average Hourly Earnings YoY 4.4%, above expectation of 4.3%
    • Average Weekly Hours 34.3, below expectation of 34.4
  • Jobless Claims
    • Initial Jobless Claims 227k, slightly above previous week of 221k
    • Continuing Jobless Claims, slightly above previous week of 1690k
  • Institute of Supply Management
    • ISM Manufacturing Report – Employment 44.4, the lowest measurement since the depths of the pandemic
    • ISM Services Report – Employment 50.7, barely hovering in the expansion zone
  • Key Take Aways

Data supports the view of a robust yet cooling labor market, where job openings are easing, hiring intentions are falling and people are generally working less hours. On the flip side, based on absolute levels the labor market is extremely tight and wage pressures are elevated, which will keep the Fed pleased with the direction of travel but aware that the destination is still off in the distance.

Key measures of labor market now at or below pre-pandemic trends, and still trending lower

Bond market sniffing out higher yields all week got boost from Fitch with a downgrade of US debt

  • Prior to the Fitch downgrade interest rates were trending higher because the “Big 3” – Food, Energy and Shelter – are all showing signs of upwards price pressures.
  • Pressure from the Big 3 impacts bond pricing because:
    • As disinflationary forces decrease the Fed may need to continue to raise rates to combat persistent inflation.OR
    • Faced with inflationary pressures in the Big 3, the Fed hold rates steady and does not raise rates, but in doing so tacitly indicates it is willing to accept a higher inflationary target, which would indicate the neutral rate is higher causing upward pressure in rates.
  • The Treasury announced that it would have to increase to planned issuance of in Q3 by $247b to $1.0t because of a shortfall in tax revenue. Keep in mind that the last time the Treasury issued this volume of debt was during the pandemic when the Fed was buying $60b month. The Treasury currently plans to issue another $852b of debt in Q4.
  • The Treasury also disclosed it is nearing its cap of 20% of issuance of T-Bills. This is significant because the excess Treasury issuance thus far has largely been focused on T-Bills, where demand from Money Markets has been absorbing the paper. If the majority of new issuance is going to have to be in Bonds, there are concerns about demand.
  • The Fitch downgrade was an inconsequential event. The big event was August 5, 2011, when S&P downgraded US debt. This was a big event because many of the contracts for collateral were written in such a way that the collateral had to be AAA, causing a mad scramble. Collateral contracts have all been re-written, to exclude US government debt from downgrade criteria, making the Fitch downgrade a reminder about the US slide towards insolvency but nothing more.

Bond market showings signs of concern about inflationary pressures and size of debt issuance

Private markets showing signs of stress from rising rates and tighter lending standards

  • Metrics form private capital markets
    • Average All-in-Yield on First Lien Middle Market Loans Q2 2023: 12.09%
    • Deal Pricing (multiples of EBITDA): Multiples have begun to compress, with manufacturing taking the largest hit (see sector chart page 9)
    • Deal Volume (number of transactions): Sponsored Buyout LBO deals declined to $6b in Q2 2023, the lowest since Q3 2020
    • Leverage (Loan to Value): Has dropped from over 55% to 43.3% Source: Monroe Capital
  • Senior Loan Officer Opinion Survey reports banks continue to tighten lending standards citing:
    • Less favorable or more uncertain economic outlook
    • Reduced tolerance for risk
    • Deterioration in liquidity positions,
    • Worsening industry-specific problems
    • Increased concerns about the effects of legislative changes, supervisory actions, or changes in accounting standards
    • Decreased liquidity in the secondary market for loans

As interest rates rise and lending standards tighten, multiples have compressed with less leverage

FAQ: How expensive are the Magnificent 7?

The Magnificent 7 trades at a Forward P/E of 40.1x. This compares to the S&P500, which trades at 19.2x. Each of the respective sectors within the S&P500 trade at:

Information Technology 27.0x
Consumer Discretionary:  25.7x
Consumer Staples:  20.0x
Industrials:  18.7x
Materials:  18.1x
Healthcare  17.5x
Communication Services:  16.9x
Real Estate:  16.8x
Utilities:  16.6x
Financials: 13.9x
Energy:  11.9x
  • The S&P500 is trading a slight premium to its respective 5 and 10-year averages of 18.6x and 17.4x
  • The table below compares the current Forward P/E with the five years prior to the pandemic for the Magnificent 7. Note, that apart from AAPL and NVDA, and to some degree MSFT, the other companies are not expensive by historical standards.

Magnificent 7 – not universally expensive by historical standards

Putting it all together

  • The labor markets are cooling at a measured pace, which is supportive of the two parts story of the immaculate disinflation narrative – a gradual decline in employment combined with disinflationary pressures.
  • A resurgence of inflationary pressures in the Big 3 – Food, Energy and Shelter – is threatening the second half of the immaculate disinflation narrative.
  • The recent spike in interest rates represents the markets attempting to come to terms with the prospects of higher interest rates for longer because of inflation uncertainty and the Federal Government’s drunken sailor spending binge creating truck loads of US government debt that needs to find a home.
  • The valuation picture for the Magnificent 7 is not universal. AAPL and NVDA, are outliers in premium from prior to the pandemic. It would be pretty easy to make a case that the Magnificent 7 is not particularly expensive by historical standards when looking at their P/Es. If their growth prospects have materially changed because AI is driving significant upside to their growth, as long as they continue to meet earnings expectations, it would be possible for multiples to expand further.
  • With the latest Bloomberg survey indicating that two-thirds of investors expecting a recession by the end of 2024, and some of Wall Street’s most prominent strategists still calling for a recession and deflation, many investors are sidelined with fear of trying to pick up nickels in front of the recessionary steamroller lurking around the corner.

For more news, information, and analysis, visit the Fixed Income Channel.


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