Michael Zeuner (00:43.826)
Hi everyone, this is Michael Zeuner, one of the managing partners at WE Family Offices. Thanks for listening to the Wealth Enterprise briefing. I’m joined today by Sam Sudame, our Global Head of Macro. And as we record in the last week or so, interest rates, particularly in the US and around the world, but measured by U.S. treasury rates, they’ve climbed to 20-year highs.
And we’re going to talk with Sam a little bit about first what’s underneath that, what’s going on, why are they climbing? Two is what does that portend potentially for capital markets broadly? And then three, how might higher interest rates to the extent that they are here for some for some time, how will they affect different asset classes going forward? So Sam, welcome. Maybe we can start.and just tell us give us some perspective about what’s going on in the bond market and more importantly, why it’s going on.
sam (01:47.164)
Sure, and thank you for having me, Michael. So we saw interest rates rise meaningfully this week. We saw the two-year jump 25 basis points in two days, which is an immense spike in rates, reaching the highest level in 20 years. But when we look under the hood of what causes 25 BIP increase, 24 of it came from a rise in real yields, and only one basis point from inflation.
Expectations. This distinction is very important. Because of the real yield went up, it shows that the economy is strong and driving a greater appetite for capital. And the catalyst, what happened this week was that this was a September PMI report. Now, this PMI report is at one of our most important macro inputs. It shows economic momentum.
We like it for two reasons. It future profits tend to track PMI as does inflation, and as a result, it’s a leading indicator for us. And in September, the PMI showed that business growth picked up meaningfully from August and surged to the fastest rate in over five years. Now, if you remember five years ago, the economy was burning hot from the enormous amount.
Of fiscal and monetary stimulus due to COVID. Today, the story is about strong organic growth. And this report showed that an economy that is not only strong, but is picking up even more steam, showing job growth accelerating, and it showed that the input costs are rising, which should lift inflation to the highest level since October 2022. But what
Michael Zeuner (03:40.956)
So Sam, go go ahead.
sam (03:43.928)
So what this reflationary and and so what you’re seeing right now is exactly what a reflationary environment looks like. As CapEx, that cylinder of economic growth is firing really hard. And what I think the big takeaway is that the 10-year rate hit a 20-year high because we have the best organic economic growth in over 20 years.
Michael Zeuner (04:12.882)
So help me understand or help our listeners understand if what you’re describing is rates going up in the public bond market because of reflationary growth, strong growth, strong fundamentals. And yet the all the talk, you know, two weeks ago was about the Federal Reserve, what it would do, and it in fact started a rate tightening cycle. But that was really being driven by an attempt to slow the economy down.
given the you know inflation, particularly in energy prices. So how do you reconcile those two perspectives? One being driven in the public bond market by growth, the other in in the Fed, which affects short term rates, really being driven by trying to slow the economy down and reduce inflation.
sam (05:01.755)
Sure. So the Fed funds rate, which you mentioned, the the Federal Reserve raised at its monetary policy meeting last week, when they raised it from 3.75 to 4% range. But what the Fed what the Fed funds rate does is it’s the Fed’s attempt to bring an economy into equilibrium, an equilibrium of its dual mandate of stable prices, which is inflation.
And economic growth, which is reflected by jobs. They want to keep the two in balance. That’s why they raised rates in order to tamp down inflation. But what they’re but inflation is rising because economic growth is very strong. So that’s the primary reason because that demand for capital causing the economy to rise is what’s also driving inflation.
Because what’s happening is you’re having this strong demand growth, but it’s also being hitting up against supply shocks. So these were policy-driven supply shocks, for example, gasoline and diesel, curtailed immigration, and tariffs. So for instance, food prices are going up because fertilizer prices are based on na natural gas. The tractors, for instance, need diesel. The trucking to get the groceries to market.
also depends on fuel. You have immigration curtail, which affects the labor that works out in the farms. So these can are causing supply side shocks, hitting that high demand increase.
Michael Zeuner (06:42.78)
Okay, so so growth and inflation, depending on where you sit, if you’re at the Fed you’re worried about inflation driven by growth, and if you’re in the public bond market, you’re demanding higher interest rates because of economic growth and the supply of capital. Now, one of the things you didn’t mention, which has been in the press a fair amount, is fear of fiscal deficits.
and and fiscal sustainability or unsustainability, which might be causing the term premium to rise. we’ve talked about that before. How do how does that factor into what’s happening recently?
sam (07:23.131)
So it depends on where you are on the curve. So for instance, the 10-year US Treasury rate is up this year about 100 basis points. 90 basis points of it is due to real yield, that demand for capital. About 10 basis points of it is based on inflation expectations. Basically, none of it is due to the increase in the term premium.
For the 10-year rate. But when we go to the 30-year rate, we saw in our previous webcast that the 30-year had increased meaningfully. And that did reflect a much higher term premium because it’s based on the credit ressentially the credit risk of the US government.
Michael Zeuner (08:14.296)
And so depending, as you say, where you are on the yield curve, the longer further you go out, the more you might see concerns about sustainability of the US and the deficit. And therefore you might see an even greater increase in rates. All of these things sort of add add into the puzzle. Okay. So now that we understand what’s happening with rising rates, whether on the short end being driven by the Fed.
to fight inflation on the medium end being driven mostly by rising growth expectations and the long end by rising growth expectations as well as questions about fiscal sustainability. what does it all mean, Sam? How does it affect the equity markets in general? and and how might it affect specific parts of the equity markets differently?
sam (09:05.787)
Sure. So you know, equity volatility has picked up meaningfully this week on the back of yields spiking. So higher yields, all else unchanged, causes the discount rate to rise and the PE multiple to fall. But it’s the speed of the rate rise and not the absolute level of yield that matters more.
And it is the spike in rates this week that caused stocks to tumble. But it’s very important to keep in mind when we talk about yields affecting stocks. So just going back in history, the 10-year Treasury rate was above 5% for nearly 40 years from the mid-1960s to 2007. And stocks had strong decades of returns in the 1980s and 90s.
But when we look at stocks right now, the same forces that are driving the reflationary environment have not only raised interest rates like we saw this year, but are also driving strong earnings growth, which is why we’re seeing double-digit returns this year in stocks. It is because of that strong economic growth, it really benefits as you go down cap.
So mid-cap stocks are doing better than large cap stocks. Small cap stocks are doing even better because str small cap stocks are very much tethered to the domestic economy, and that domestic economy is doing very well.
Michael Zeuner (10:49.808)
And yet don’t higher rates have a a more profound impact on smaller cap stocks than large cap?
sam (10:59.299)
They do. One of the reasons why is a lot of the small cap debt is floating rate. So as yields go up, those interest rates that they have to pay go up. And being small cap, they can’t really lock in long-term financing through the bond market like large caps. But because you have earnings growth growing a lot, that can offset the increase in interest expense for them.
Michael Zeuner (11:27.154)
So again, we come back to the theme, which is that a rise in interest rates being driven primarily by growth is not necessarily a very bad thing over the medium term for the equity markets. What about other asset classes, Sam?
sam (11:45.532)
Sure, so let’s take a look at real estate. You know, we haven’t really talked that much about real estate on our podcast, but you know, the same thing I see happening in commercial real estate, where a reflationary environment is driving up cap rates higher, causing cap rate decompression, but that those same forces are causing occupancy rates to rise and supporting lease rates.
As a result, the higher NOI growth, net operating income growth, should more than offset the rate compression. When we look at commodities, commodities are because they’re driven by supply and demand, and demand is very strong. So for instance, building out data centers requires a lot of metals. You see, a reflationary environment is very good in general for industrial commodities.
So those are riding that economic growth theme.
Michael Zeuner (12:49.43)
It does seem, Sam, that, you know, at a very macro level, all roads lead back to strong growth and strong economic conditions, which I guess is how one can interpret what’s going on in the bond market and the fact that it’s not necessarily cataclysmic at this point. What what could go wrong, Sam? I like to ask you that question. What could go wrong and what could turn this
increase in bond yields into something more problematic and more troublesome.
sam (13:22.981)
So when we look at a few areas, one is what what’s happening to real estate. this is more like the single family home. So we have seen mortgage rates rise meaningfully, mortgage rates breaking the 7% mark. If you remember just a few years ago, those mortgage rates were around 2.5%. As a result, there’s been a dampener on home building.
And home building is actually one of the most powerful of the economic cylinders of growth. It just so happens that the CapEx cylinder is firing so hard that it’s overcoming that. But over the long term, it’s really depressed real estate for single-family homes. Another area that it can impact is that it’s actually gold. So the higher yields is actually negatively impacting gold.
Gold likes the uncertainty, but higher real rates really is a headwind to gold.
Michael Zeuner (14:27.058)
So so some some asset classes to keep an eye on as a result, but broadly speaking, for diversified broadly diversified investors, so far things look okay to you from from your position.
sam (14:41.807)
Yes, and also the one th caveat that we’ve been maintaining is if interest rates go up, that is negative for very long duration bonds, which is why we’ve been advocating be prudent on the interest rate risk.
Michael Zeuner (14:57.99)
they short to intermediate, reinvest at higher rates until until we see, you know, w w what’s your view of where the the sort of ceiling is? How high could rates go?
sam (15:12.219)
So when we look at rates, so the 10-year rate, what we look at are the three components, would be economic growth, inflation, and term premium. So when we see how high can rates go, if we think inflation will be around 2.5%, we add that to a plus two percent in economic growth, takes us to more than four and a half percent.
The term premium is about 80 basis points, but as time goes on and US debt to GDP keeps rising, that 80 bit term premium can rise even more. So this week, I would not be surprised to see the tenure in that five and a half to six percent rate.
Michael Zeuner (16:01.222)
And then would you start to worry that it could derail some of the growth?
sam (16:06.393)
Yes, at that point, the cost of capital starts to increase. And as a result, companies can start to invest less. Then buying a home becomes even more expensive. So at some point, the higher cost of capital will cause the economic growth rate to start to be impaired.
Michael Zeuner (16:27.856)
To be clear, we’re not there yet. So let’s let’s keep an eye on that. Let’s you and I continue talking about that. As always, Sam, thanks for your insight.
sam (16:36.955)
All right. Thank you, Michael.
