The day after BSW’s last quarterly update in July, the movie Barbie hit theaters, offering a reflection of our economic landscape. In the film, Ken and Barbie live in the seemingly perfect world of Barbie Land, only to encounter harsh realities when stepping into the real world. Similarly, we contend that the markets existed in a comparable utopia, akin to Barbie Land, for over 12 years leading up to and through the pandemic. This period was marked by unusually low interest rates maintained by the Fed and other central banks.
Yet, the real world shattered this illusion of stability, the pandemic upended the global linkage, and with the breaking of this fragile economic peace came serious disruptions, resulting in the high inflation we witnessed last year. This prompted a response from the Fed: a dramatic increase in interest rates. The transition from Barbie Land to reality was abrupt.
Rising Interest Rates: Impact on Business Models and Investments
In our opinion, the days of Barbie Land stability are behind us. You might have heard the phrase “higher for longer,” meaning interest rates will be higher than zero, which is a very low bar. There are many persistent drivers of deflation like technology and debt, demographics that can naturally slow down price increases over time, we believe these factors will prevent the Fed from maintaining its current restrictive policy for much longer. As we understand it, many business models underwritten in a very low interest rate world are struggling to find a strong footing in our new reality. The increase in bankruptcy filings this year, a topic we have covered before, is one indication that this is testing the bounds of sustainability.
Inflation readings exceeding the Fed’s target of 2% inflation measured by CPI, continue to push interest rates upward. While the most recent 3.7% year over year increase may seem like an improvement, concerns linger that it could rebound toward its 2022 high of 9.1%. This fear has likely kept the Fed hawkish, even increasing the Fed Funds rate by 25bps in late July, accompanied by indications of another hike later this year. From our vantage point, this reaffirms the likelihood of higher rates persisting for an extended period.
The Fed’s own estimates hint at a long run rate of closer to 2.5%, significantly higher than the 0% policy of the last decade. This figure, while significantly higher, aligns more realistically with the anticipated economic growth.
Consider the complications arising from congressional dysfunction, delayed government shutdowns, coupled with a persistently high federal budget deficit leading to record treasury bond issuances. Adding to the complexity, the Fed’s decision to engage in Quantitative Tightening, selling off bonds from its portfolio, it shouldn’t be surprising that the 10-year treasury rate climbed from 3.85% at the beginning of July to nearly 5% in recent weeks. Ouch! The stock and bond markets took notice, selling off by ~8% and ~4.3% respectively over that time.
Housing Market Dynamics: The Conundrum of High Rates and High Prices
Rates are particularly painful for levered purchases, like homes. A 30-year fixed rate mortgage now demands interest at 7.63%, the highest it’s been in 23 years.
This might suggest houses are on sale, but the reality seems to be quite different. Zillow.com and the Case Shiller home price index just recorded the highest home values nationally, ever. The impact on homeowners is staggering: mortgage payments at today’s rates on the median home price (Zillow) now consume 31.8% of the median household income of $74,800, versus 15.5% in 2019. Although this statistic might seem dramatic, it likely only affects a small percentage of homeowners as many have locked in low rate financing in recent years and have no plans to sell. This kept housing inventory off the market and transaction volume at the low levels last seen in 2011.
These challenges aren’t confined to the housing sector alone, they extend to both private and public sectors of the economy. For example, consider the US federal government spent $711B on bond interest in 2023, a substantial increase from the $375B in 2019. Whether at the household level or within an enterprise, these higher costs divert money away from other investment and spending.
Despite these challenges, the economy’ s response has defied. One key factor that could be contributing to its resilience is the substantial liquidity transferred from the federal government to individuals and companies during the pandemic. Although this infusion of cash, while significant, has yet to be fully utilized. Additionally, the economy is likely still recovering from substantial production and consumption setbacks during the pandemic. Indicators such as employment and corporate profits signal that things are not all that bad.
Investment Insights: Stocks, Bonds, Real Assets, and Private Equity
In the world of investments, 2023 has been a year of significant fluctuations and trends, here is a breakdown of our insights across various asset classes:
- Stocks
Stocks have performed well year to date, with the global index we track returning about 9.39% (year to 9/30/2023.) In the meantime, the Magnificent Seven comprising tech giants like Apple, Google, Amazon, Nvidia, Meta, Tesla, Microsoft, have almost doubled in value. This has contributed to the historic level of stock market concentration in a few stocks and of the US stock market as a percentage of global markets. Amidst this scenario, international and value investing begin to look more appealing, offering diversification in a concentrated market.
- Bonds
With rising interest rates, bonds have faced challenges. The Bloomberg Aggregate bond index has seen a decrease of 1.21% year to 9/30/2022, which is an improvement compared to the 13% drop last year. Despite these challenges, we believe bonds are becoming more attractive. Why? Because market driven inflation expectations for the next 10 years sit at 2.4% and a 10-year treasury close to 5%. We believe adding high-quality bonds should help with capital preservation and income generation.
- Real Assets
In real assets, commercial real estate has captured headlines as it suffers the double whammy of rising interest rates and a new paradigm of office utilization. Conversely, rental housing in many areas continues to thrive due to a scarcity of units. Within our portfolios, we attempt to minimize exposure to office real estate and emphasize apartments and diversifying into real assets like infrastructure and farmland. In our opinion, these investments offer our client’s exposure to investment returns that are often different from traditional investment real estate and have some appealing long-term tailwinds such as those for renewable energy and organic farmland conversion. Our goal is to build allocations in real asset investments for diversity and portfolio resilience.
- Private Equity
We value investing in private equity because so much of global corporate ownership is transacted in private, not public, markets. Incorporating private equity can offer a premium for investing privately and enhance diversification. The move in rates has particularly impacted venture capital, which is only one facet of our private investing. Longer term, we see opportunity in this sliver of private equity as valuations become more realistic.
Long-Term Investing: Lessons from History and Strategies for Today
I recently had a birthday, so I thought it would be interesting to reflect on all that happened in the year I was born. Consider a snapshot from 1974:
-The US economy produced a GDP of $1.5T
-Median household income was $11,100
-Mortgage rates were 9%
-Federal budget deficit was 6.1% after having averaged over 20% the prior three years
-Consumer sentiment was a low 64.4
Exasperated: How did we make it?
Investing the median household income from that year in the S&P 500 would have been a daunting decision. Each year brought new worries, be it war, banking crisis, bubbles, impeachment attempts, or a pandemic. Along this journey, that portfolio would have experienced losses exceeding 50% multiple times. Despite these setbacks, today the investment would be worth almost $2M (including reinvested dividends). While we understand that such a stock concentrated portfolio is not appropriate for most investors, it seems to underscore the importance of long-term investing strategies.
Not everyone has 49 years and the intestinal fortitude to get the 180X return of the example above, and there is no guarantee such an outcome will occur again. However, we believe that by carefully selecting a combination of asset classes held with discipline and diligently managed within your personal time horizon, they should make a positive impact on your long-term investment journey.
As always, please talk to your advisor if you have any questions about your portfolio allocation. We’re here to guide your investment plan over time, just like Barbie and Ken’s enduring charm.
Elias Bachmann,
Director of Investment Group
