For several years now we have held the view that US interest rates would trend higher for longer, and so they have. Driven by huge government and corporate borrowings, as well as sharply rising oil prices, the annual inflation statistics have jumped from about 2.5% to 3.5% depending on the particular statistic.
At last, the Federal Reserve Board of Governors has become convinced that inflation has remained too high for too long and, President Trump notwithstanding, raised short-term interest rates at its September meeting. It is expected that they will not raise rates again until December because the next meeting is just before the mid-term elections, and doing so would be seen as a political “no-no!” A one-month delay in raising rates further is of little consequence.
The US government now owes $40 trillion! A 1% increase in interest rates adds $400 billion per year to what the US government – that is, its taxpayers – must pay the investors who buy US Treasuries to fund its borrowing. The full effect takes about seven years, as the Treasury refinances maturing bonds. That $400 billion equals 20% of the already excessive $2 trillion annual government operating deficit. It’s an ugly picture, and it explains why the Federal Reserve is so concerned about inflation, let alone its impact on the US population.
And yet the stock market indices are close to all-time highs! That reflects extraordinary profit growth – most pronounced in the technology sector, but also running at about 15% in the other sectors. The tax benefits of the One Big Beautiful Bill, combined with corporate capital investment, have created a powerful driver of corporate profits this year and, possibly to a lesser extent, in 2027. Profits for the S&P 500 are expected to increase 32% this year and about 16% next.
Finally, we think two further factors may lift the stock market over the next 5-6 months. First, now that it appears that the Federal Reserve is serious about tackling inflation, and is likely to be persistent about it, we would expect a decline in US Treasury yields at the long end of the curve. Even though raising short term rates should have limited effect on inflation itself, it may have a positive effect on longer term inflation expectations. Good for stocks.
Of course, the implied flattening, or possibly inversion, of the yield curve would start people talking about a recession – one that might never come, given the investment boom. This would be bad for stocks but also a potential buying opportunity.
The second event may be the mid-term elections. While the Democrats are expected to win the House, it is less clear whether they will win the Senate. We are not political analysts but the gridlock in Congress that may occur if one or both of these events takes place may be seen as positive in that “gridlock” does provide a kind of certainty that hasn’t existed since the President took office. That might be seen as positive for stocks and perhaps is already partially reflected in the market averages.
We note that the price-to-earnings ratio of the S&P 500’s technology sector has fallen from 26 at the start of the year to 20 today – less because prices have declined than because earnings expectations have risen. Over the same period, the ratio for the non-tech sectors has fallen from 21 to 18. Together, these lower valuations provide some comfort.
Beware the Risks:
1) Local opposition to new data centers may slow capital investment. Working through objections takes time, which could significantly delay the build-out and raise its cost. That said, we suspect the noise is louder than the actual obstacle, given developers’ aggressive willingness to address objections and get on with the projects.
2) Failure to resolve the war in Iran may prolong the drawdown of oil reserves that is already pushing up product prices. In Asia, for example, landed crude costs not $105 a barrel but $150, once insurance and other costs are added.
3) We suspect it may take another two years to secure alternative supply routes that bypass the Strait of Hormuz.
4) As homes become less affordable, would-be buyers may turn to renting instead. Higher demand would push up rents, which make up the housing component of the inflation indices – raising inflation further!
What to Do
Rising stock prices have shrunk the share of client portfolios held in money market funds. Depending on each client’s risk tolerance and asset allocation, we may either rebuild the “cash position” or continue adding to technology as opportunities arise.
David R. Kenerson, Jr., President
D. Ryder Kenerson, III, Managing Partner
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