Although the spike in real rates is not sustainable, Empirical Research Partners said that investors are diversifying their portfolios more than ever, tilting towards free cash flow generators.
A reversal in real rates would boost both the value and high-growth ends of the market, said Michael Goldstein, managing partner, in a strategy report.
He explained why.
Real 10-year Treasury bond yields (US10Y) have increased by more than 115 basis points this year, from which more than 95 basis points have increased just this second half. Also, in the last six months, the bond market’s yields have surpassed the equity market.
“And more than 60% of the return dispersion of stocks can be explained by interest rate changes,” Goldstein wrote.
He explained that four dynamics, comparable to the 1970s and 1980s, have produced the current environment:
The economy has outperformed expectations this year. Demand grew at a more than 5.6% year-over-year rate in the third quarter. Also, higher rates have tightened financial conditions, “but by less than expected,” he said. Home prices have not reduced, and the S&P 500 Ex-energy (SPXXEGP) earnings will be up more than 8% in the fourth quarter.
The budget deficit has topped forecasts by several hundred billion, “in part a function of lower capital gains realizations,” he said. Issuance increased in the third quarter, and foreign purchases amounted to about a third of the $2.7T in FY2023, even when excess savings have reduced globally.
The Federal Reserve has reduced its balance sheet by about $640B this year so far and has reversed the repo book contracted by $1.5T. “The effects of those actions and the issuance were exacerbated by a high level of rate uncertainty.”
At its September meeting, the Fed raised the forecast for real short rates by more than 50 basis points, and real rates went up by a similar amount.
“The stickiness of inflation has contributed to the rate uncertainty and led investors to price in a higher-for-longer scenario,” Goldstein wrote. “On top of that, the term premium, that proxies for the time value of money, is up by almost +60 basis points this year to 1.3%, the highest reading in almost a decade.”
A gradual disinflationary cycle seems to be happening, he said. The quit rate in the service industries is back to normal, and asking rent prices for apartments are falling as supply has increased.
The CPI shelter component, which amounts to 40% of the core index, was up by more than 8% in September, even when asking rents fell.
In addition, some of the factors that produced “exceptionally low” real rates in the 2010s, including the production and use of technology that caused a disinflationary effect, reducing prices for capital goods, and globalization, are still operative, Goldstein said.
“Real long rates currently exceed the likely trend growth rate of the economy and appear to be somewhat too high, the product of a perfect storm,” he added.
