Questions, questions, questions. Investors always have lots of questions, most of them about the future, which makes them very hard impossible to answer. That doesn’t mean the questions aren’t worth asking though, which is why I do this every few months. Thinking about what we don’t know can prepare us for the future no matter how it turns out. And today, as always, there are lots of things we don’t know. So, let’s get to it. 

Will interest rates continue to rise? This is probably the most important question for investors, especially equity investors. Interest rates are up across the board this year but how they’ve risen is maybe more interesting than that they have. The 30-year Treasury rate has gotten a lot of attention lately because it is at its highest level since 2007 but it is not the part of the yield curve that has seen the largest rise this year. The rise was steepest at the short end of the curve (2-year up 70 basis points) and shallower as you go out on the curve (5-year 64 bps, 10-year 53 bps). The 3-month T-bill rate did not follow that pattern, up just 36 bps on the year. What does that mean? The market is expecting rate hikes but not right now and maybe not at all. The odds of a 0.25% rate hike do not exceed 50% over the next year. Even more interesting is that the rise in rates this year is not about inflation fears. The 10-year TIPS yield is up 49 basis points this year almost exactly the same as the nominal 10-year; inflation expectations are barely changed this year. As I’ve been saying for several years now, rates are in a trading range and until they move out of that range, don’t expect much change in the economy. The key level to watch, in my opinion, is 5% on the 10-year note. Breaking above that would break the trading range and probably have a pretty negative impact on stocks.

Do high equity valuations today mean stocks are vulnerable to a selloff? Well, sort of. Equity valuations are high today because earnings growth expectations are high. The two things that could impact equity prices are a change in those earnings expectations or a rise in interest rates. With the S&P 500 earnings yield at about 4.75% (based on a forward P/E of about 21), the equity risk premium (the excess return an investor requires to hold stocks versus bonds) is probably about 2.5%. The long-term average is around 4.5% so, theoretically, stocks are more vulnerable to rate rises today. But earnings expectations are probably more problematic. Today’s expectations are historically very high, around 18% for the next two years. Historically, growth rates like that over a short period of time have been associated with recession recoveries, coming off a low base. There are exceptions but they are rare. Since 1950 earnings growth of the magnitude expected today happened only about 10% of the time and it was always from a starting valuations that were cheaper than today. A disappointment seems more likely than not.

Why are real rates so high today? The classic answer is that there is high demand for capital for investment and we’re certainly seeing that today, especially now that the AI buildout is being financed with debt. But there are other reasons real rates can rise: persistent fiscal deficits (bond supply shock), Fed balance sheet shrinkage (QT), deglobalization (reduced trade surpluses elsewhere mean fewer dollars to recycle into Treasuries), increased risk aversion in bond markets (rising term premiums). We have some degree of all of these today so the rise in real rates has many causes. Whatever the cause, higher real rates offer solid competition for other investments. Longer term TIPS today offer real yields that are competitive with a range of assets. Real yields on long-term bonds have averaged 2 – 2.5% since 1900 and you can lock that in today with a 10-year TIPS (2.4%). Real returns on equities have been higher but not when valuations are this high. Using various techniques, expected US real equity returns over the next 10 years are 2 – 4% and you can get all or most of that from TIPS. Don’t look at high real rates as a potential problem; look at them as an opportunity.

Is the current fiscal situation sustainable? With the national debt approaching $40 trillion and annual deficits running 6% of GDP, it seems hard to believe we haven’t had a crisis yet. I’ve been hearing about the coming fiscal crisis for my entire career and so far the market has had no problem absorbing more and more US debt. Is there a limit? I suppose so but we haven’t found it yet. The other fear of large deficits is that the larger government borrowing will “crowd out” private investment causing the economy to stall. Yeah, not so much. You can draw a straight line from government deficits to corporate profits. And government deficits don’t make corporations less credit worthy or reduce bank’s capacity to lend, which are the real constraints on private sector borrowing.

Will Japan’s fiscal problems impact global markets negatively? This is another one that keeps getting asked year after year and never seems to come about. Japan’s government debt makes the US situation look quaint. At 250% of GDP, Japan’s government debt is the highest in the developed world. The flip side of that coin is that Japan is also the world’s largest creditor with a net international investment position of about $3.3 trillion with about a third of that in US Treasuries. The fear is that if Japan is forced to raise interest rates quickly to defend the Yen,  Japanese capital will be repatriated, meaning a sale of those foreign assets, including their Treasuries. Which explains why Treasury Secretary Bessent was so eager to buy Yen recently. Over the last few years there’s been a lot of discussion about de-globalization and its impact on the global economy but not much about the potential blowback from de-globalizing finance. Unwinding cross border investment could get very messy.

Will inflation moderate or continue to get worse? I am of the opinion that the long-term interest rate cycle has turned. After a 40-year bull market in bonds, interest rates are now in an uptrend. Why? Demographics, de-globalization, lousy monetary policy and excessive government debt. There has been a persistent narrative for the last 30+ years that Japan proves that an aging population is deflationary but I’m not buying it. Japan experienced deflation (actually what they experienced was stagnation of prices; Japan’s prices rose at an average annual rate of about 0.3% from 1990 to today) for the same reason the rest of the world experienced low inflation – China’s entry to the world trading system. De-globalization, if it is realized in size, would reverse that. I won’t go down the monetary rabbit hole here because it would take too much time but I don’t think anyone believes monetary policy has been done properly in a long, long time. As for government debt, by itself it isn’t necessarily inflationary but the response to it often is. Given a choice of austerity or inflation to reduce government debt/GDP, which one do you think politicians will choose? I expect inflation and interest rates to continue rising over the next decade or more. I could be wrong but based on the current trajectory, I’m pretty comfortable with that outlook. But not too comfortable; I’ve been wrong a lot in my life and while I’m older, that doesn’t mean my psychic abilities have improved.

Will the Iran War eventually push energy prices much higher? Probably the biggest surprise of the war is that crude oil prices haven’t risen more. Still, energy prices are up a lot this year: Heating oil has doubled, gas prices are up 85% and crude is up 43%. Natural gas is the exception, down 26%. Why isn’t crude trading over $100? A variety of reasons: China demand drop, strategic reserve releases, re-routed shipments, big production from US and other non-OPEC countries (Guyana, Canada, Brazil). What’s the likely long-term outcome? I have no idea but I think now that Iran knows the leverage they have over the strait of Hormuz, they are unlikely to give it up. ME countries are going to spend a lot on finding alternate routes to get their products out (pipelines, etc.) but that will take time. An outright blockade isn’t in anyone’s interest, Iran included. Given all that and other things we can guess at, I’d say the base case should be for prices to remain elevated but not back up to $120 where it went right after the war started. There’s good and bad in that for the US obviously. The US is a big producer of crude so higher prices are a benefit but higher fuel prices hurt consumers (individuals and corporate).

Will China use this time of reduced US military capacity to take Taiwan? Anything is possible but I don’t see the point right now. Cui bono? If China took Taiwan, they could turn the entire global economy upside down but why would they do that now? They are in the midst of trying to export their way out of a debt problem and weak domestic demand. Killing the global economy right now would not be in China’s best interest.

Will the rest of the world be able to move away from China supplies of critical minerals (rare earths, etc.)? The Trump administration is pursuing the mining of these materials through investments in several companies but the real bottleneck is processing/refining of these materials. China controls roughly 60% of rare earth mining globally but 90% of refining capacity. The administration has funded several companies in this area too but progress is very slow due to permitting and environmental issues (there’s a reason we stopped doing this a long time ago). We also lack the expertise of China which has spent decades perfecting the refining processes. China has also made inroads in this business outside of China, particularly in Brazil. The bottom line is that China has a lot of levers to pull when it comes to rare earths. I don’t think this problem gets solved any time soon and in the meantime, it gives China a lot of leverage in trade negotiations.

Will the trade wars get worse or will the Trump administration come to its senses? President Trump seems unlikely – in the extreme – to change his mind on tariffs regardless of the evidence. The problems he is trying to solve are real but his solution isn’t working and it isn’t just a matter of time. Will other countries start retaliating more? Well, it isn’t in their best interests so I hope not but history says that domestic politics often trumps common sense. So, yes, we’ll probably see a more complicated trade picture going forward if the administration can find some form of tariffs that allows them to bypass Congress and that can be upheld by the Supreme Court. If the Supreme Court rules against the new round of tariffs, I’m not sure where they go next but getting Congress to approve tariffs at anywhere close to current levels seems unlikely. In any case, getting the case to the Supreme Court, as we found out last year, is not quick. One thing I can say about the past tariffs is that now that refunds are being processed they look like a windfall and a convenient stimulus for growth prior to the mid-term elections. One of the reasons corporate earnings have been good recently is that tariff refunds go straight to the bottom line.

We ask questions as investors to think through the possibilities and maybe even assign some probabilities. The goal isn’t to become a better forecaster but to become a better decision maker. If you know what assets to favor when interest rates are rising and what to favor when they are falling, it doesn’t matter much why interest rates are changing. Of course, figuring out the why would allow you to make a better decision so we try but it isn’t strictly necessary. Asking questions allows us to prepare for whatever comes, even if it isn’t what we expect.

How we ask questions matters too. The questions above are actually related, one leading to the next. The first question about interest rates leads to the second question about equity valuations which leads to the third question about real interest rates which leads to the fourth question about our fiscal situation which leads to the fifth question about inflation. One question always leads to another, each question intended to help us with whatever decision we need to make. If interest rates continue rising, we know stocks probably won’t have a lot of tolerance for that because the risk premium is low. That knowledge will help us make a better decision if interest rates keep rising and break out of the range they’ve been in for 4 years.

Successful investing under conditions of uncertainty – which is always the case – requires situational awareness*, a term we’ve heard a lot recently. You can’t know the future but you have to know the present. 

Joe Calhoun

*A hedge fund named Situational Awareness, run by a very young AI guru, managed to lose $35 billion over a few days in late July. Certainly, the young manager had no situational awareness when the correction in AI stocks took out his fund. On the other hand, according to news reports, his fund is still up on the year so maybe he’s not so dumb after all.