The senior CNBC markets commentator on inflation, Fed policy, the economic outlook, market risks, and more.
Our guest this week is Michael Santoli. This is Michael’s second appearance on The Long View, his first coming in August 2021. Michael is senior markets commentator at CNBC, which he joined in 2015. Prior to that, Michael was a senior columnist at Yahoo Finance, where he wrote analysis and commentary on the market and economy. That followed a long stint at Barron’s magazine, where Michael was a columnist and feature writer for 15 years. Michael began his career in the early 1990s as a reporter, covering the securities industry for Dow Jones Newswires. He earned his bachelor’s degree from Wesleyan University.
“Michael Santoli: Navigating Through a Foggy Market Outlook,” The Long View podcast, Morningstar.com, Aug. 9, 2022.
Bonds and Interest Rates
“KKR’s Henry McVey Makes the Case for Real Assets,” Squawk on the Street, cnbc.com, Sept. 14, 2023.
“AI Hype Lifts Microsoft Shares at Alphabet’s Expense. An Opportunity May Be Investing for Investors,” by Michael Santoli, cnbc.com, Feb. 8, 2023.
Economy and the Stock Market
“Stocks Churn With the S&P 500 Sitting at the Same Level It Was Two Years Ago,” by Michael Santoli, cnbc.com, Sept. 16, 2023.
“The Stock Market Is Stuck in a Typical but Anxious Seasonal Pullback,” by Michael Santoli, cnbc.com, Sept. 9, 2023.
“Collective Embrace of Soft Landing Economic Scenario Extends 2023 Rally After Welcoming Drop in CPI,” by Michael Santoli, cnbc.com, July 15, 2023.
“Stock Market Heads Into the Second Half With Near 15% Total Return so far in 2023,” by Michael Santoli, cnbc.com, June 24, 2023.
“Is It a Bull or a Bear Market? Stocks Churning in Same Spot for Weeks Frustrates Investors,” by Michael Santoli, cnbc.com, April 22, 2023.
“Explaining the Relative Calm of the Stock Market as the Fed Hikes Rates Into a Mini Financial Panic,” by Michael Santoli, cnbc.com, March 25, 2023.
“Run on Silicon Valley Bank Injects Some Panic Into an Already Slumping Stock Market,” by Michael Santoli, cnbc.com, March 11, 2023.
“Resilient Stock Market Finds Support at Just the Right Time, Preserving Uptrend,” by Michael Santoli, cnbc.com, March 4, 2023.
“Who Is Right? Bulls and Bears Each Have Reliable Indicators Backing Them in This Confusing Market,” by Michael Santoli, cnbc.com, Feb. 11, 2023.
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is Michael Santoli. This is Michael’s second appearance on The Long View, his first coming in August 2021. Michael is senior markets commentator at CNBC, which he joined in 2015. Prior to that, Michael was a senior columnist at Yahoo Finance, where he wrote analysis and commentary on the market and economy. That followed a long stint at Barron’s magazine, where Michael was a columnist and feature writer for 15 years. Michael began his career in the early 1990s as a reporter, covering the securities industry for Dow Jones Newswires. He earned his bachelor’s degree from Wesleyan University.
Michael, welcome back to The Long View.
Michael Santoli: Well, thanks very much. Good to be back with you.
Ptak: Well, it’s our pleasure to have you back. We wanted to start with the fixed-income market and yields at more than 4.3% on the 10-year at the time we speak. That’s the highest we’ve seen yield since 2007 if I’m not mistaken. Given you’re a keen observer of the stock and bond markets, we’re curious to know what message do you take away that you think the bond market is trying to send to investors?
Santoli: Well, for one thing, the message from the Federal Reserve that they anticipate keeping rates higher for longer, I think, is starting to register to some degree in the fixed-income markets. You can look ahead at the futures curves and what potential rate cuts might be priced in for various times into next year. But to me, the long end of the curve is partly building on this idea that rates are not quickly going to go back to extremely low levels where we came from. And then, there’s some sense out there … The real yields, inflation-adjusted, are up to around 2%, which is the highest in quite some time. And I’m sympathetic to a bunch of different arguments as to why that is right now.
One is, and this comes from my friend Henry McVey over at KKR, suggesting that the economy and inflation might be at a higher resting heart rate than we became used to. So, there may be higher nominal growth potential embedded in those expectations. Maybe inflation does not calm down or the overshoots on inflation happen to the upside. And then, I think it’s unknowable how much the size of current federal deficits and the amount of Treasury issuance that we all know has to happen is playing into that. That’s one of those we can talk about it a lot; it’s hard to measure. But to me, all of that is in the mix. And I find it interesting that, because it’s been so long since it was routine to have long yields above 4%, there’s a combination of a novelty factor where people feel as if this is a great opportunity and a combination of and also a sense out there that this is somehow going to test the fragility of the economy in the markets. But I go back to periods of time when we managed to do OK, you can search for a new equilibrium in terms of what the economy is capable of doing and what the equity markets can handle. But we’ll only know as it unfolds.
Benz: You hinted at this in your last response, Michael. Inflation breakevens haven’t risen that much over the past year. So, the rise in interest rates is explained mostly by a jump in real interest rates. Why are real rates rising do you think?
Santoli: There’s a chance that collectively the bond market is saying, one, it needs to be better compensated for taking longer-term risk in bonds; and two, that maybe there is the chance that the economy is going to run a little bit hotter where the risk big picture is on the inflation side as opposed to the deflation side or the high nominal growth side versus the stall side. I guess that’s a possibility. And again, I feel as if I can’t deny that the supply concerns are part of this. But it’s very tough to actually isolate that as a factor in the moment. So, it’s fascinating. I think one thing that you might take away from it is whatever the reasons for higher real rates that perhaps they create a little more of a cushion in terms of returns in fixed income. But I guess that’s something for the specialists in that area to really decide.
Ptak: I wanted to ask you about AI, which raises the tantalizing possibility of big productivity gains, which I would think we tend to associate with lower, not higher interest rates, despite that rates have risen. Do you think that’s because the Fed story is just crowding out any potential productivity gain story, and that’s the main reason why we have seen rates creep up the way they have?
Santoli: I would suggest that it’s just way too early in this AI buildout investment process for the markets to confidently handicap and price in any productivity gains that we get from it. I come at the AI story as a whole with a pretty high burden of proof to me that this is something more than, guess what, software gets better, smarter, faster all the time. And that’s generally what has happened forever. And maybe we’re in an accelerated moment where it’s happening much more rapidly to much more tangible effect. But right now, if I look at the way the stock market is capitalizing this opportunity, it’s mostly about a hardware buildout of capacity in AI and data center investments that have to happen to the benefit of those people selling those actual tools and chips.
And we’ll see later if this is all money well spent. We’ll see later what the economic payback is off of this in terms of productivity. I have no doubt that it’s probably going to be that. But right now, it’s much more about people spending in an urgent way because they feel compelled to do so because the opportunity might get away from them or they may be disadvantaged. So, I think it’s just too early for us to say productivity is going to have this step function higher and therefore that’s disinflationary and all the rest of it.
So, it is also one of those things where productivity is—it’s a residual number that comes from other calculations. I don’t know. I have a little bit of skepticism about it. And it’s also why this is a funny moment in macro in terms of trying to really discern what’s happening because we’re at this time of the conceptual theoretical variables like real rates, like potential growth, like the neutral rate of interest, like long-term productivity gains where it just feels as if it’s not very here and now. It’s not the absolute cost of money. It’s not the absolute growth of the economy in nominal terms. And I’m not saying those are wrong or false. I just find it difficult to believe that the market has a handle on any of those things in the moment.
Benz: I wanted to go back to inflation. Headline inflation ticked a little higher recently amid rising gas prices. Does that change the Fed’s posture in your opinion?
Santoli: I don’t think it changes the Fed’s posture in a dramatic way in the immediate term. They’re certainly on alert for the idea that the next bit of progress on inflation is going to be more difficult. I don’t think gasoline prices, energy prices in general will necessarily be that swing factor. I know there’s so much easy cynicism about the exclusion of food and energy from core inflation to figure out the actual trend. Part of the reason I’ve always thought is not just that those prices are volatile when it comes to commodities, but that demand isn’t elastic enough that if you’re forced to pay more for food and gasoline, you have less discretionary income and ability to drive inflation in other parts of the economy. So, it’s an offset on some level. I don’t know that it would really change things.
And interestingly, one place that it could potentially show up is consumer inflation expectations. So, we haven’t really seen that yet. It’s early. I think we’re on alert for all of it, for both sides. The Fed wants to be done, I think. The Fed wants to be able to be patient. I think one of the reasons the stock markets performed reasonably well this year is that the Fed is not really chasing inflation. It’s gotten to roughly where it needs to be. Any moves from here are going to be relatively incremental and spaced out. So, I think for now, it’s probably fine.
I would also point out that based on the Fed’s own assumptions, they weren’t anticipating getting inflation down to its 2% target very soon anyway. So, they’ve been giving the process time. If they feel as if they’re in restrictive territory on rates and QT is happening and they’re monitoring progress. So, I don’t think it changes the equation, but it seems like a pretty delicate balance. Above $90 on WTI. We’re getting toward $4 national average on a gallon of gasoline. Yeah, I think that that creates stresses, but arguably it creates even more stresses on the demand side of the economy and consumer confidence than it does on inflation. So, that’s why it’s tricky at this point.
I was pointing out that we were at this level of national gasoline prices, nominally speaking, for a little while in late 2014, most recently. So, since 2014, since October 2014 to now, the average hourly wage for production and nonsupervisory workers in the economy has gone from $19 to $29. So, back then, you were paying $3.80, you’re making $19 an hour at the median, and now it’s paying $3.80, you’re making $29. So, the energy intensity of spending has gone down in a GDP, but I don’t think that means you can be complacent about it.
Ptak: We wanted to talk about the economy and the state of the consumer in a moment. Before we did that, though, I did want to ask you about the yield curve, which remains inverted. Can you think of a good reason, at the risk of sounding a bit glib, to extend duration if there isn’t a long-dated liability to hedge? Like, why would somebody do that?
Santoli: I don’t think it’s a no-brainer to do so, for sure, to say the least. I think that the argument for doing so now is essentially that is reinvestment risk on the short end. So, if you actually think that there’s a high enough probability of the economy goes into a tailspin, the Fed, despite what it says, is going to have to be cutting your 5% in two-year yields or shorter is not going to be 5% over the 10-year span of a 10-year note. So, that’s probably the reason, plus you get a little bit of real yield, and maybe it’s just rebuilt the portfolio-hedging capacity of longer-term fixed income as we’ve gotten yields up to this level. I think to me, that’s just textbook, I guess, but that’s the only real reason if you wanted to make a macro and economic call and a market call about why it makes sense to do so right now.
Benz: Switching over to the economy. The stock market has been rangebound. I’m wondering, is there any reason to believe the market is beginning to sniff out economic weakness, the equity market?
Santoli: Yes, it’s difficult. In pockets, arguably, yes, you’re able to say that. As has been constantly noted, it’s a very uneven market in terms of the performance this year. S&P 500 is obviously not exclusively but largely driven by the noncyclical mega-cap growth stocks. You’re up 16% on that group. And then, the equal-weighted S&P is up 4% this year. So, clearly, there’s a lot of differentiation happening.
I have been encouraged that things like homebuilders to a lesser degree and also industrials broadly speaking seems like what they’re pricing in is just capacity, scarcity, and the need for an investment cycle and capacity. Industrials are working there. But I do think that the market implicitly is mostly priced for continued somewhat benign economic conditions except in pockets of consumer cyclicals where I do think you’ve seen some wear and tear clearly on pure retail-type stocks but even hitting things like airlines. So, you have to squint, you have to decide what the message is. But at this point, I do think that the market is very indecisive about how late we are in the cycle or maybe how long we can stay late cycle. I think I recall that debate from 2018/2019 as well where you could say we’re late in the cycle because unemployment is so low and the Fed’s almost done tightening perhaps, but that doesn’t really tell you how much sand is left in the hourglass.
Ptak: When you look at the economic fundamentals, what jumps out as the biggest positives and the biggest negatives at this point where we are?
Santoli: I think the biggest positives are perhaps the initial conditions from which the economy has had this maybe slowdown. The Fed has had to tighten. Meaning, consumer and corporate balance sheets just being much healthier. We talked about the supposed excess savings among consumers having been largely depleted. But the fact is, there was a lot of excess savings and you’ve actually been able to see that in the household aggregate leverage numbers. Obviously, it’s not equally applied. So, there’s some stress at the lower income side of things. But I would say that just in general the initial state of consumer and corporate balance sheets were a big positive. And this long stretch of time at very high nominal growth and high wage growth and low unemployment, it seems like it’s created a level of activity that’s not necessarily going to get depleted all at once. So, those would probably be the positives.
The negatives are: how much better can those things get? When you got to 3.5% unemployment, you might be bumping toward some kind of structural low in unemployment and there’s clearly been a reset of interest costs higher that is working its way through. So, I’m not of the opinion that, well, the Fed managed to hike 525 basis points, 10-year yields went from 50 basis points to 4.3 and we didn’t really feel it. I don’t think we really didn’t feel it. I think that it’s there, it just has some offsets that we’ve been enjoying for a while now.
Benz: When we had you on last time, you correctly predicted that this economic cycle might not resemble the cycles of old where a slowdown leads to sharply higher unemployment. As a matter of fact, the labor market has remained really strong even amid fears of a slowdown. Do you see that markedly changing?
Santoli: I’m not that confident one way or the other on that. I think that there’s probably initially a reluctance to reduce payrolls as much as there would have been in the prior cycles because we’ve just come out of this period of labor scarcity and companies know that. But, I don’t know. I think you’ve been able to see enough moves toward preserving of profit margins, and I think there will be some softening up of labor market conditions. I have to admit I was skeptical of Fed chair J. Powell saying that perhaps we can cool off the labor market just by having job openings come down a lot and not necessarily have unemployment go up much. That’s exactly what’s happened to date pretty much, and I thought that that is plausible but not likely and it was just more importantly the thing he would have said whether he believed it or not at that point. Because if you know things have to get tighter, if you know the economy has got to slow, if you know that the job market is too hot, you’re going to be raising rates and you might as well put it out there and say, I’m not trying to kill the labor market. But my point is that it has been more resilient than they may have anticipated. There was an uptick in labor participation in the latest payroll report, though I’ve seen some work that suggested that it was more attributable to fewer people leaving the labor force than many new people entering it. So, it seems like it will be stickier than in past cycle, but I don’t think that that’s immunizes us from an uptick in inflation. You’ve seen unemployment claims turn higher to a degree—still at very low levels—but directionally, I think things are inching that way.
Ptak: Wanted to go back to talk about the state of the consumer. I think you alluded to it in an earlier answer. How is the consumer doing? Last time we spoke you had pointed out that the consumer had built up some cushion thanks to fiscal stimulus and other factors. At this point, have they largely burned through that—and I suppose it will vary by segment or strata—and what might that augur for spending to the degree that they maybe have burned through some portions of that, if not all of it?
Santoli: Yeah, I certainly think it’s pretty apparent that a lot of that cushion has been worn down. To the degree it exists, it probably is largely among somewhat higher-income, wealthier households. So, I think we’re back to basically having wage growth determine what works and of course, real wage growth is key, too. So, I think that, yes, even though we’ve had some periods of time when headline inflation has receded below the average wage growth, it hasn’t been point to point that way for the last couple of years. So, I think that’s where you’re seeing stress. I look at things like the charts of the shares of the Dollar Stores which have been just in free fall recently to say that there’s clearly stress. It’s on some level a bit of a zero-sum game.
I don’t know how much it matters in aggregate. There are so many odd features of this current phase for the economy, such as if you own a home, 60%, or whatever percentage—a large majority of people are locked in at very low mortgage rates. I’ve seen a lot of interesting work, too, on how much personal interest income has gone up in aggregate given what’s gone on with cash yields and short-term bond yields and the like. So, at the moment, we’re getting by, but I think that it’s hard to argue that the consumer is in better shape now than a year ago.
Benz: Mortgage spreads have widened and that is worsening housing affordability. Before we talk about what might push spreads toward equilibrium, can you explain the dynamics that influence the difference between longer-term Treasury yields and mortgage rates?
Santoli: Yeah, the spreads have been uncommonly wide. On one level, demand for mortgage-backed securities in itself is something that absolutely would drive those spreads. Keep in mind, the Fed is allowing its balance sheet to shrink. It’s rolling off a lot of securities, many of the mortgage-backed securities. So, there is a little bit of a mismatch perhaps in short-term supply/demand, not because they’re selling them outright, but they’re no longer a buyer and in aggregate more to come on. But also the regional banks, the last thing that they want is to add further duration in the form of longer-term mortgage security. So, I think a lot of that is feeding into it. I’m not sure if there’s a quick fix for it, but it’s one of those things that’s really helping to hang up the housing turnover.
Ptak: What do you think it will take for a mortgage spreads to narrow? You talked about some of the variables—supply, demand and the like—but if you try to imagine a future state where spreads revert back toward what we consider normal, what do you think are the key things that need to happen or not happen for that to take place?
Santoli: Absent obviously the Fed deciding to slower end quantitative tightening or restore QE—by the way, I’m not actually that big a fan of thinking that the Fed’s balance sheet really is causal of that many things, but this seems to be one of those that at least if just for short-term supply/demand and psychological factors is there. I suppose if it got to the point where there was a little more trading capital in there, if regional banks started to feel flush, if you started to have some regulatory changes that allow bigger banks to maybe shoulder some more of that. I’ve seen some work that suggests that maybe that could help. But it’s interesting in the sense that with overall yields going higher, it feels as if investors have less need or incentive to take more risks than they might otherwise want. And so, even though mortgage is not the riskiest part of fixed income, it seems as if there’s just not enough ready buyers that rather just stay in some safer stuff. Because it’s fascinating—corporate spreads have been very well behaved, especially on the investment-grade side. So, it seems as if that they are an outlier where you had a typical class of reliable buyers in that market that are just not in the mode of adding assets of that type.
Benz: We’re seeing a lot written about how frozen the residential housing market is given affordability challenges and scarce supply. You’ve alluded to that in your responses to previous questions. Do you see evidence that this is dragging on the broader economy?
Santoli: I suppose there was an effect when housing activity was first taking a big leg down. Even just in a simple way of, like, residential construction. Employment did go down 2% or 3% from the highs, although it did tick higher again in the latest month. But it’s interesting how it has not seemed to have as much impact as you might have thought. It’s clearly the case that for a while we were floated on the fact that home prices continued to be high, there’s a lot of housing wealth out there that finds its way perhaps into the economy in various ways. So, I think you could argue that there was a period certainly last year when it helped to cool the economy off to a fair degree. But at this point, it’s not, to me, one of the big worry points. Obviously, overall activity level is low, but it doesn’t seem to be really steering the economy in a bad direction.
Ptak: Do you see a scenario where housing prices fall even amid scarce supply, or do you think we need to rebuild the inventory of available homes for that to really be plausible?
Santoli: It’s a tough question. The way I view it now is, when you’re seeing home prices stay this high, it’s almost like a stock when you have a very thin float and only 5% of the outstanding shares actually freely trade and you have these somewhat unreliable prices and it’s prone to overshoots. So, I do see that as being the case for a while. I guess affordability, if you start to see unemployment tick up and you just have potential buyers fall by the wayside eventually that would have to hit prices. But when you also have things like new homes still selling pretty well to fill that gap, because it is such a huge gap in supply, and those new homebuilders are able to buy down the mortgage rates and keep the nominal prices relatively steady, it seems as if we can go this way for a while. I’m certainly not a close analyst of the residential real estate market, but I’ve been surprised to date at how it’s held up. And I know the reasons. We could all describe the reasons. It seems as if over time you would have to get a little bit more of give on the pricing side because affordability is just stretched so thin.
Benz: We want to talk about corporate earnings. How would you describe the most recent earnings season and what might that portend for corporate profit growth for the rest of the year?
Santoli: I think the big picture is, we’ve had a series of quarters where the results were a good deal better than forecast on paper, certainly better than feared, but the market itself didn’t necessarily take a lot of comfort in that or didn’t directly reward those companies that were beating on earnings. I think the reason for that is, we all know the game. It seems to be priced in by the market. The buy side did not think that they were going to come in as expected. But more importantly, it seems as if the second quarter is going to be the trough for earnings growth in aggregate for S&P 500 earnings. So, based on the current forecast, they’ve been inching higher. We will have seen a trough in profitability and then leading toward significant year-over-year gains into next year, whether that holds up or not.
I’m sympathetic to the idea that we had a somewhat mild earnings recession. There was a little bit of strain in some sectors to protect profit margins. It’s definitely a top-heavy earnings story. If you look at the revisions, the upward revisions to S&P 500 earnings in the last, let’s say, couple of months, it has been skewed toward the very large Nasdaq stocks. And they have such an outsize effect that when Meta, and NVIDIA, and Alphabet have their earnings estimates go up, it really does move the needle on the whole. So, I think, the market reset lower with a valuation shock and an inflation shock and a Fed policy shock last year, also pricing in a mild earnings recession. We’re sort of trudging out of it, but the market, of course, has tracked higher as well. So, we do have valuations that still on the surface look on the rich side because of all that, but I do think it’s been somewhat encouraging that earnings resuming growth based on the consensus is kind of an offset to the macro-slowing story and the higher-yield story that we’ve been dealing with.
Ptak: What’s been the biggest disappointment from a corporate profit standpoint? And on the flip side, what has pleasantly surprised you that you’ve seen?
Santoli: Obviously, financials are just a mess on the earnings side, banks in particular. Actually, there’s a bit of an interesting separation going on between banks and nonbank financials right now in terms of stock performance and earnings, but that would clearly be the sloppiest area of the market. And then, consumer staples really have faltered. The stocks have performed poorly. They had downward revisions, not impressive in terms of guidance. And it seemed to suggest that the pricing power they enjoyed was relatively fleeting and cyclical over the past year or two, as opposed to being something that they could count on, because their costs clearly have also gone up. So, I would say those would be the main themes in terms of disappointment.
And then on the positive side, it would be things like the big-growth platform companies, they seem to just be able to—it’s something like a meta where they just magically can pull the lever, decide to stop spending billions, and it doesn’t affect really the top line at all. And so, they’ve been able to harvest a lot more than they might have expected. And industrials, it’s very interesting when you look at the industrials sector as a whole, that, yeah, clearly there’s a transportation side of it, and that’s subject to a lot of the typical old cyclical and inventory bill dynamics and things like that. But if you look at the industrial conglomerates, the true kind of wholesale business-to-business-type companies, they’re much steadier. They’re almost more staplelike than anything used to be. Even though there’s a capital expenditure cycle going on, and they’re reaping the benefits of it. A lot of what gets categorized as industrials are really just these necessary business-services type things. And that’s an area where I think that is a big explanation for why the industrials have managed to perform better.
Benz: Corporate profit margins have been resilient, and they improved in the most recent quarter. Beyond the obvious factors like passing along input cost increases by raising prices, what explains this resilience and how sustainable are corporate profit margins at this level?
Santoli: There’s a couple of levels of that, one of which is, if you’re just talking about the S&P 500, there has been a sector effect there, which is, so much more of the S&P 500 is essentially growth companies, or essentially technology-driven, relatively high return on capital type businesses. That’s where the market cap lies. Scott Chronert over at Citi has done some good work on just talking about how the S&P itself, and just equity market cap in aggregate, has become a lot more weighted in those types of companies as opposed to the old days of a lot of boom-bust manufacturing and material. So, that’s one side of it.
I guess the other piece of it is, honestly, interest and taxes have gone nothing but down in recent years, and that’s, of course, going to change this year when it comes to interest. But that’s part of it. And I guess I have to give a nod in the direction of those people who say, in general, large companies, perhaps, are better managed, or there has been enough survival of the fittest activity, winner-take-most-type dynamics in various sectors that you have more defensible profit margins. I don’t know how much weight to put on those ideas, but it seems like we’ve gone from profit margins being called an incredibly mean-reverting cyclical factor to one that seems like it’s at a higher plateau in general at this point.
Ptak: Higher interest rates haven’t been an issue for company profits, despite the fact that they’ve risen recently. Companies seem to have largely shrugged them off. When do you think that changes where higher rates become a threat to profitability?
Santoli: I think if you look at large companies, it’s been very muted. Smaller companies, where they’ve reset their interest expense quickly, that to me accounts for the fact that small caps have suffered so much is one of the major factors. It is a function of time to a degree. As many have commented, in 2020/2021, there was just a huge corporate issuance boom, folks refinanced for years on end, and you have that lock-in effect on rates.
The other piece of it is—and again, this is another thing we didn’t really have to do the work on for many years—had so much of the S&P market cap are companies either with high net cash balances or just high absolute cash balances. And guess what? They’re earning 5% on the cash. It sounds silly, but if the whole S&P was one company, and you did the income statement, there just is a very blunt effect of higher rates because of the offset to some degree of what they’re getting on their cash. But it can’t last forever. The corporate credit market, as I said, has been well-behaved in terms of spreads, but the absolute yield levels are higher now than they were. And you are seeing defaults go up. It’s in the dozens per month, but on the high-yield side, it’s taking its toll, but I think slowly and incrementally. To me, what I would worry about is if you had any kind of sudden dislocations caused by it as opposed to just that undertow of higher interest expense. And we obviously have to feel the pinch on margins, and maybe you’re going to have higher hurdle rates, and you’re not going to invest as much in all the rest of it. For now, I guess it’s all happening in a very slowly unfolding way, and we’ve been able to, in the short term, make our peace with it in terms of the market.
Benz: We wanted to ask about the stock market. Despite rising rates, stocks have performed really quite well this year with the Nasdaq leading the way. What explains that dichotomy?
Santoli: I guess a couple of things. One is, you can’t get away from the outsize impact of the very large companies that are just a little bit less cyclical. But even aside from that, the way I would view it is, in retrospect, certainly, it seems as if we got, in 2022, a non-recessionary bear market. Yeah, there was probably an earnings recession, maybe in retrospect, it will seem as if there was a more serious economic slowdown accompanying it. But we did get that 20% to 25% equity index decline into October, and it ended right as inflation peaked. The October CPI print from 2022, as soon as we got it, the market said, that’s the peak, and you buy the peak in inflation. And so, I do think that the big explanation for it is not just the fact that inflation has come down faster than the economy has weakened this year, but that the volatility of inflation and the volatility of fixed income and the perceived volatility of monetary policy have all settled down a lot. So, I think that I’m definitely a believer in those things as being major factors for why you’ve had a willingness of investors to take a little more equity risk, to rebalance back toward stocks.
I think there’s a significant “now what?” question on the way, whether it’s now or whether it’s in a few months if the market happens to get a fourth-quarter rally and go back toward the all-time highs. Because it feels to me as if the 20%, 25% decline we got last year, that runs out of time in terms of discounting an economic downturn. It’s sort of like it expires. Its value in handicapping a macro downturn is not going to last forever. So, we’re going to be a little more on even footing, and we’re going to have the election-year dynamics. And maybe it seems like there’s a little more of a two-way market where you have some headwinds to deal with. But for now, I think we’ve been feeding off of the combination of the ebbing of inflation and bond market volatility, and as I mentioned before, of course, this apparent upturn in corporate profits as well.
Ptak: As you know, we had a banking scare not too long ago, but the market seems to have moved on. Do you think that we’re potentially sleeping on other hazards that might be lurking in loan portfolios or elsewhere?
Santoli: I would never say no to a question like that. I do think that financial accidents or the raw material for them is always there somewhere. I guess right now there are so many eyes on those exact bank balance sheet duration issues that I am not sure I’m as concerned on that, even though they do create this perpetual drag on credit creation and all the rest of it. I would also note that if I constantly look at these charts comparing one type of stock to another, and if you just do the Nasdaq100, like the Magnificent Seven growth-stock-dominated indexes relative to just an equal-weighted S&P 500, the divergence was almost to the day when Silicon Valley Bank failed. Starting in March of this year, you saw all the kind of perceived safe balance sheet secular-growth companies win back all the valuation premium that they had given up last year, and the typical stock that might be subject to a little more of the financial conditions that we have to deal with has lagged. So, I don’t think that the market is oblivious to that possibility, but I watch all the credit market indicators for a sign of that. And that’s why I think that bond market volatility is, if anything, almost more important than equity vol right now, because that to me tells you if the stresses are starting to arise in the system or not.
Benz: For years, we had this TINA idea that there is no alternative to stocks, but now there are actual alternatives. The S&P 500′s earnings yield was recently sitting just below 4%, whereas nominal intermediate and long-term Treasuries beat that, and you can also lock in about 2% real per year in TIPS. So, why aren’t stocks selling off given those more-attractive options today?
Santoli: I guess it is a little bit of a puzzle. I’ll dial back though to one thing about the TINA idea. So, when that notion was ascendant in the 2010s, the premise is, there is no alternative to stocks, and yet net equity inflows in aggregate were pretty anemic that entire time. And rates stayed really low the entire time. So, the market was saying, I don’t know, I guess bonds are a good alternative because I’m not selling my bonds. You know what I mean? So, the idea that what an individual should decide on an asset-allocation basis in terms of risk/reward was completely logical, like let me just stay involved in stocks even though I think the economy might be vulnerable to shocks or go into recession. So, I get it why it’s an explanation for why the market behaves. But also, when we were talking about TINA in 2014, the equity risk premium was huge. You had a 14 times earnings on a 2% Treasury yield or something. So, I find it interesting that people have the TINA idea when behavior wasn’t really tracking the idea that there was no alternative to bonds.
So, now dial up to now, there are alternatives. I do agree that on a portfolio basis, fixed income can serve its role again, you have positive real yields, it makes all kinds of sense and yet yields keep going higher because there seem to be more sellers than buyers in bonds right now. Some of those sellers are to the U.S. Treasury. So, it’s not just about investors deciding to sell their bonds.
Bigger-picture question on equity valuations relative to fixed income—it’s become my pet idea that there’s just so much squishiness in that relationship. So, when we go back to that spread between the earnings yield of the S&P 500 and let’s say, the 10-year Treasury, right now, that seems like there’s just no valuation cushion at all for stocks. We’re as low as we’ve been in 20 years-ish. But if you go back to the ‘80s and ‘90s, this level was absolutely routine and unremarkable, and the market went up most of that time. It’s not the case for real yields. When you had 2% real, stocks should probably be a little bit less expensive than they are.
I guess, my big point is, I just don’t have a lot of faith in the precision of those relationships. The biggest equity bubble in history happened when yields were at 5% and 6% and 7%. They are not that predictive. I know that the CFA exam math tells you it has to matter, and I know that it does on some level. But in the moment, it just doesn’t seem to have that much sway. And I will also say that the 2010s and to a lesser degree, the 2000s, were an era when not only did we have very, very low policy rates, but the perceived big-picture risk was deflation. And now the perceived big-picture risk is perceived to be inflation as it was in the ‘80s and ‘90s. And so, if you say, OK, what we have now is 10-year yields above 3% and the big-picture risk is inflation, that looks a lot more like a pre-2000 world than it does a 2000s world. And so, therefore, the equity risk premium today isn’t crazy relative to what we used to see back then. So, I guess, that’s a very long way of saying, I don’t have a ton of confidence in the precision of those relationships because it’s very regime-specific. So, absolute valuations, they don’t look cheap, certainly because they’re also dragged up by the seven stocks at the top of the S&P that trade at 30 times or something.
Ptak: I wanted to go back to something that you’ve referenced a few times, which is the fact that the U.S. equity market at least is top-heavy. The top 10 holdings recently soaked up around 31% of the S &P’s weight, which is the highest it’s been in, I think at least, I don’t know, I want to say 30-some years based on the data that I had available to me, maybe ever. It’s probably also the case that more of the S&P’s earnings are tied up in those top 10 than at any other point. But do you think the concentration is worrisome, just the sheer amount of weight in those top 10 names?
Santoli: I do think it’s potentially worrisome, certainly for an index investor. I guess I would make that distinction. Because I often do ask folks who decry the concentration of the market and say, what exactly are you complaining or worried about? Is it that the market is in fact not as strong as it would appear based on the S&P 500 because of a small number of stocks? Is it because, as many might argue, a broader rally is a more durable rally, and a broader advance is something that has stronger underpinnings and therefore is less vulnerable? All those things I can see as being reasons why you’d be focused on it. So, I do think that it’s not ideal for a market-cap-weighted index investor to have those stocks there.
On the other hand, it does reflect to a degree, as I said before, the winner-take-most nature of some of the core industries of today’s economy. The one measure, valuation measure on which the current equity market as a whole doesn’t look egregiously overvalued is free cash flow yield. Free cash flow, maybe eye of the beholder, maybe it’s not always the most airtight metric, depending on how companies report it or how you view it. But it is the case that those super huge trillion-dollar-plus market-cap companies deliver on balance more free cash flow than others. So, I think that there’s a way to explain it away to a small degree.
I also think that it’s almost a new definition of perceived safety and predictability. It’s in these companies as opposed to in Procter & Gamble and IBM in the old days. It just so happens that they have like $800 billion up to $3 trillion market-caps and therefore are so big in the index. So, I do worry a little bit about it mostly because it says not enough other stocks are participating. If the economy were in a better spot or we had a clearer line of sight toward the economy improving or staying strong, then I would expect those other stocks to do better.
The S&P equal weight is up like 17 or something percent from the October lows of last year. It’s really gone nowhere in a year and a half. So, I don’t think it’s really telling you a clear story, either good or bad, about what’s happening underlying, except that it’s just stuck. So, yeah, that’s why I feel like it’s an indecisive market and I think that it’s hard to have high conviction about whether we can believe the message that a very strong return on the S&P so far to date is offering. I did also point out in a comment I wrote this weekend that the three, five, and 10-year returns on the S&P are basically all in like the 11% to 12% zone, which means the market doesn’t owe you much from this point. It’s what you would expect, maybe a bit better than average, but on the two-year basis, we’re dead flat. Interestingly, we’ve been tracking a flat on a two-year-trailing-basis path for a while now for several weeks, I’ve noticed. So, we’re just following the 2021 trajectory, having given it all up in 2022 in a way.
Benz: Some are arguing that small caps are screaming bargains relative to large caps. I think our equity analysts are pointing to a level of undervaluation there in the small-cap row of the style box. Do you subscribe to that view and if so, do you think that it’s advisable to tilt toward the stocks of smaller companies?
Santoli: I’m certainly sympathetic to that view on a long-term mean-reversion basis. You’d have to make the argument that something profoundly has changed in these fundamental relationships to look at those charts of relative valuation of small caps. They’re basically maybe even cheaper than in 2000 or around the same level and say that you shouldn’t actually expect that valuation gap to close somewhat. Everything I said about the super mega-caps maybe works against that a little bit, this idea that they maybe have been able to hold their valuation better. But I at least take comfort in the idea of small caps have taken their pain. For whatever macro downturn, whatever reset of interest rates we got, it has registered in small caps. So, if nothing else, it would seem as if the risk has come out of them to a fair degree on a long-term basis.
The other thing, I always do go back to that period when people show you the relative performance of small versus large and you go back to 2000, it absolutely was a great time to tilt toward small. But a tremendous amount of it happened because large-cap growth imploded, as you know. So, it wasn’t so much in absolute terms, it was some kind of bonanza for small caps in a straight line. But certainly, the risk had come out of them, and you were set up for much better relative returns for a little while.
Ptak: The last time we spoke, you sounded an optimistic note about the U.S. 60/40 portfolio, which was in the midst of a tough stretch. A year later, it’s obviously a different story. How do you see the outlook these days for the 60/40 portfolio, especially in view of the fact that we have higher bond yields to prop up that 40% of the portfolio that perhaps weren’t as evident if we went back a couple of years ago?
Santoli: As an entry point today, I would say, I still think it makes sense, because as you say, you do have the higher initial yields. There is that cushion. And I guess maybe that doesn’t mean you should expect a lot of absolute return out of the fixed-income side. I would look at some of the models that say expected equity returns are maybe lower than the long-term average from here, but not negative, certainly. So, it seems like it makes sense. Again, as an initial entry point, we’ve taken some more pain in bonds. I’m not one to say that that’s got to end right now. But when you have the 5%-ish carry in the fixed-income side, it can certainly cover for things.
The other argument against it right now is, we’re back in a world where stock and bond correlations seem positive, but that’s where we were before 2002. It’s not as if there’s going to be this perfect offsetting choreography of equity versus fixed-income returns. But over time, if they’re both slightly positive on a total return basis, it seems to help and makes the ride maybe a little bit smoother.
Ptak: Well, Michael, this has been a very enlightening conversation. Thanks so much for sharing your time and insights with us.
Santoli: It’s my pleasure. Thanks again for having me.
Benz: Thanks so much, Michael.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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