Capital markets continued their rebound after a strong October with the S&P 500 returning 5.6% after an 8% return in October. The S&P 500 is now 13.7% off its highs after falling 25% through the middle of October. The U.S. Aggregate Bond Index, which fell 1.3% in October, rebounded 3.8% in November as interest rates fell on a better-than-expected CPI report on November 10th.
The Consumer Price Index (CPI) report showed inflation rising 7.7% year-over-year which is the lowest reading since January 2022. Signs of “normalization” in the post covid, post stimulus, and post zero interest rate environment are starting to show in the inflation figures, particularly in core goods costs. Currently, supply shortages remain in certain industries, but the frequently cited container ship backlog off ports in southern California has now fallen to zero after totaling over 100 ships in January. This has led to a sharp 80% decline in global container freight shipping rates. The cost to ship a 40-foot container from Shanghai to Los Angeles, which peaked in January at $11,197, is now at its lowest rate since the middle of 2020 at $2,262.
(Chart: American Shipper based on data from Marine Exchange of Southern California)
Regarding the “normalization” of the post stimulus and post zero interest rate environment, the CPI report showed the price of merchandise increasing 5.1% year-over-year. This is a decline from 6.6% in October and well off the multi-decade highs of 12.3% in February. The index showed appliances, furniture and bedding, apparel, and used vehicle prices declining from October levels. While these categories each had year-over-year gains, the monthly decline in core goods costs reflected slowing demand, a result, at least in part, of the actions of the Federal Reserve and reduced stimulus efforts from the Treasury. On the other hand, core services inflation remains elevated and matched its fastest annual pace since 1982. Core services, particularly the cost of shelter, continue to be the dominant factor in monthly increases in the index with rents rising 7% year-over-year and 0.7% from October. Shelter inflation is slow to move so these prices will remain high in future inflation reports. Positively, real time data suggests that the increases in shelter costs are moderating as single-family home prices and rent, affected by higher interest rates, are starting to slow.
The slowing inflation figures has investors now anticipating a smaller increase in the Fed Funds rate on December 15th. The probability of a 0.75% rate hike fell from 44% at the start of November to 23% at the end of November. Over the same period, the probability of a 0.50% rate hike increased from 48% to 77%. Higher interest rates have been a focus for equity investors as tighter monetary conditions have historically led to recessions or periods of slow economic growth. In addition, increased competition for capital (higher bond yields making bonds more attractive v. stocks) and a higher cost of capital both affect stock valuations. The impact on valuations has already been significant this year with the trailing price-to-earnings ratio falling from over 28x in 2021 to 19.5x today and the forward price-to-earnings ratio falling from 23x to 17.4x. But what is potentially more important to the market and investor sentiment is the difference between returns in raising interest rate periods versus falling or flat rates, which is why the market is highly focused on a potential Fed pivot from raising rates. Since 1985, the S&P 500 compounded annual return during rising rate periods is 11% (lasting on average 1.94 years) v. over 16% during falling or flat rate periods (lasting 2.92 years).
While we anticipate lower stock returns going forward, the data suggest that maintaining stock exposure makes a great deal of sense for longer-term investors.
The potential fed pivot in coming months would remove some uncertainty in the market regarding how high interest rates will go, but the market always finds a new risk to cling to such as how long will rates remain this high and the potential for an earnings recession. We remain focused on finding businesses with operations that are resilient in different economic cycles, inflationary conditions, and interest rate environments. It starts with fundamental bottom-up analysis of balance sheets and cash flows that allow a business to not cut corners and not compromise the integrity of its balance sheet in slower economic periods. These businesses will find themselves with high quality products and services at strong values to their customers allowing them to take market share from those businesses that do not have the same high quality balance sheet, cash flows, and operations when the economic cycle turns around.
All of us at LVM extend our best wishes to you and your loved ones for a happy and blessed holiday season!