Over the weekend the opposing US parties pushed the government close to a shutdown just to pull it back from the brink with the usual eleventh-hour deal that is commonly seen when an election is on the horizon. Deal or no deal, US public finances keep deteriorating. Tax receipts are falling despite high inflation and wage growth and the budget deficit is now set to widen.
At the same time, even the Federal Reserve acknowledged that its confidence in ‘high rates for longer’ is growing, as it has shifted to the path of rising interest rates. While it may sound like bad news for the USD and USD denominated assets, ‘weaker public finances’ and ‘stubbornly high interest rates’ may be true for the US right now, but things continue to look up for the S&P 500.
Growing US confidence in ‘high for longer’
Rising confidence that the Fed’s policy rate will stay high for longer is becoming a stronger tailwind for US yields. US fiscal policy, which is currently intensively under debate, will also most likely contribute to higher bond yields over the longer term.
With a government shutdown avoided due to a last minute ‘stopgap bill’ on Saturday, Congress now has until November 17 to build a new budget. While the potential cyclical weakness of an eventual, prolonged government shutdown could bring bond yields down for some time, any compromises made in passing a new budget could extend the currently unsustainable fiscal stance and drive US Treasury yields higher over the medium term. Ongoing solid investment demand despite high interest rates adds further upward pressure.
Why is the S&P 500 still doing well?
While investors currently focus on the common notion that rising yields are bad for equity valuations, the higher interest rate environment has a positive impact on overall S&P 500 earnings. The technology heavyweights of the S&P 500 used the early days of the pandemic to lock-in ultra-low interest rates with long maturity profiles on their outstanding debt.
Given the sharp rise in global bond yields since the start of 2022, these companies now have the ability to reinvest their large cash positions at a more attractive yield, leading to a decline in net interest expense. Hence, these companies are not feeling the negative consequences of higher refinancing costs and probably will not for at least the next few years.
Eurozone cooling on all fronts
Amidst the potential for increased rates in the US, incoming data shows how quickly the eurozone economy is cooling. Last week’s monetary aggregates reflect that the tighter monetary policy is working well, as credit dynamics continued to slow sharply, and excess liquidity decreased.
Most importantly, the disinflation process is gathering pace in the eurozone, according to last week’s published flash consumer price index prints for September. Eurozone inflation fell more than expected with the headline reading at the 4.3% level on a year-on-year basis, compared to 5.2% in August. While a more detailed breakdown will only be available later this month, the better than-expected reading points to the fact that current disinflation goes beyond the already known base effects.
Altogether, this should allow the European Central Bank (ECB) to act more carefully in their rate setting behaviour, with the focus shifting to how long the ECB might keep its stance in restrictive territory.
What does this mean for investors?
We expect the USD currency to keep benefiting from the US’s growth and rate advantage – and US equities with it. Most notably, earnings at large US corporates are much more insulated from, if not boosted by, ‘high for longer’ interest rates.
As a result, these companies are not feeling the negative consequences of higher refinancing costs and probably will not for at least the next few years. This stands in stark contrast to the small-cap space, which remains vulnerable to the higher rate environment given that 32% of the debt here is floating, leading to a rise in refinancing costs. Going forward, we recommend continuing to focus on large-cap growth names mixed with some defensives, while avoiding the small-cap space, which will have a difficult time navigating the current challenging macroeconomic backdrop.