An Increasingly Positive Outlook from Wall Street
The U.S. economy and consumers have been a lot more resilient in 2023 than many expected. Entering the year, most economists predicted a recession due to the high inflation rate and the aggressive interest rate increases from the Federal Reserve. Flash forward to mid-August, and inflation has been declining for over a year with many indicators predicting further declines; however, gas prices may alter the journey. The economy has been growing well above expectations with Q2 real GDP growing 2.4% on an annualized basis and Atlanta Fed’s GDPNow is projecting Q3 growth to be a whopping 5.8% (as of August 16).
Many of those economists have dramatically reduced the odds of recession while others remain convinced it is only a matter of time. Also, investors are growing increasingly positive and think the Fed may pull off the ‘soft landing,’ which is a slowing of the economy enough to bring inflation back in check without causing a recession. On the flip side to this positive economic picture, there is a decreased potential need for the Fed to lower rates. As a result, investors are finally shifting to higher for longer rates, even though Chairman Powell has been transparent on the process.
While the Fed controls overnight lending, they don’t control longer-term maturities; that is left up to market forces which take into effect the short-term rates and market expectations. Since investors have been expecting an eventual cut to interest rates due to a weakening economy, the 10-year U.S. Treasury had rates lower than the short-term rates (known as ‘inversion’). With the changing market outlook, 10-year Treasurys, while still inverted, have jumped to the highest levels since 2008.
The growing positive outlook from Wall Street has expanded into other areas. Investors demand a premium for the debt of companies over the Treasury to compensate for the increased risk. The spread (interest rate premium over Treasurys) for investment-grade and high-yield companies has been steadily declining as investors become more comfortable.
This chart displays the premium (yield) various corporations must pay above the Treasury with the same maturity, also known as the spread. So, according to the index on 8/11/2023, investment-grade bonds would pay 1.29% higher than the Treasury yield of 4.17% (using the 10-Year Bond), so the total yield of the investment-grade bond would be 5.46%.
Why does this matter for equity investors? Most companies rely on debt to fund day-to-day operations, so when credit is ample and not too prohibitive, companies can continue as normal. They get into trouble when it dries up and need to cut expenses when credit isn’t readily available. Also, the rosier outlook may get other investors more comfortable in the equity markets and there may be less selling pressure from the fearful. At the end of the day, many investors can be driven materially by their emotions: greed or fear.