Our updated regional banking sector outlook is available here, and the weekly data shows a continued decline in loan growth in small and large banks, see the first chart.
The slowdown in loan growth is driven by Fed hikes and tighter lending standards following the SVB collapse.
With the Fed on hold until the middle of next year, these trends are likely to continue, and loan growth will soon turn negative.
The Fed has since the beginning of 2023 steadily increased its estimate of the long-run fed funds rate, see chart below. The implication for investors is that the Fed is beginning to see the costs of capital as permanently higher. A permanent increase in the risk-free rate has important implications for firms, households, and asset allocation across equities and fixed income.
The consensus is expecting a slowdown in GDP this quarter, driven by household savings drying up, student loan payments restarting, and impacts from high interest rates hitting consumers harder and harder. Additionally, the October jobs report—which will be released on November 3—is expected to show a decline in job creation. With the Federal Reserve raising interest rates since March of 2022, the cost of capital has been rising. This has been putting downward pressure on stock buybacks. Other factors playing a role in this trend include increased tax risks as well as recession and geopolitical worries. The bottom line is that companies seem to be less inclined to pursue buybacks and instead are holding on to the capital they have on hand to run their operations.
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There is downward pressure on buybacks because of worries about a recession, the new tax on buybacks, and higher cost of capital.
These three forces make free cash flow more valuable for companies, see chart below.
Calculating the equity risk premium using trailing earnings and forward earnings shows that stocks are at their least-attractive levels in 20 years relative to bonds, see charts below.
The equity risk premium measures the return in the stock market minus the return of the risk-free rate, and it tells investors something about equity returns relative to fixed-income returns.
In the equity risk premium formula, equity returns are normally calculated by looking at the S&P500 earnings yield, i.e., the inverse of the P/E ratio. Using forward earnings expectations can be misleading when the consensus expects a 55% chance of a recession, so another variant is to look at the S&P500 earnings yield using trailing earnings.
Either way, the bottom line is that with 10-year interest rates close to 5%, the stock market today is more unappealing than it has been in 20 years, see again charts below.
The market is currently pricing that the FOMC will start cutting rates in June 2024, but the chart below shows that the market is almost always wrong about what the Fed will do beyond the next FOMC meeting.
Looking at the chart, it is remarkable how mean reverting the error is.
When rates are low, the market is systematically pricing that the Fed will soon hike.
When rates are high, the market is systematically pricing that the next move from the Fed is to cut.
Maybe the Fed will cut rates next summer. Maybe not.
For now, investors should be planning on rates staying higher for longer.
Key measures of inflation have reaccelerated in recent months, and supercore inflation at 4% is too high compared with the Fed’s 2% inflation target, see charts below.
The bottom line is that it is too early for the Fed to declare victory over inflation, and the Fed needs to slow down the economy further to get inflation under control.
The implication for investors is that the Fed will keep rates high until nonfarm payrolls go negative, because that is what is needed to get inflation under control, and this fact is generally underappreciated in markets.
The Fed has quantified what their forward guidance and balance sheet policy mean for the fed funds rate, and their estimates show that the proxy fed funds rate is 7% rather than the official 5.5%, see chart below and here.
In other words, comparisons with history and discussions of how restrictive monetary policy is should not only look at the level of the fed funds rate but also include forward guidance and balance sheet policies, including their impact on long rates.
Student loan payments restarted on October 1. And the Census Household Pulse Survey for October shows a jump in the share of consumers saying they are having difficulties paying their household expenses, see chart below.
Looking at the Household Pulse Survey in detail shows that the difficulties with paying household expenses were concentrated among households with a college degree, making between $50,000 and $150,000, suggesting that restarting student loan payments is the source of increased financial stress for consumers.
There are 33 million small businesses in the US, and the monthly survey from the NFIB shows that small businesses are now paying 10% interest on short-term loans, see chart below.
In other words, Fed policy is working as the textbook would have predicted, and companies are facing higher costs of capital.
The outcome is lower capex spending and lower hiring.
