Navigating the Bond Market: Rising Deficits and Interest Rates

Get ready to unravel the mystique of the US market as we draw parallels between the 1987 crash and the current market situation. You might be wondering, how can US futures remain strong amidst looming Federal rate hikes, growing China tensions, and Middle East instability? Don't fret, we've got you covered. We'll tackle the bond market's structural challenges, why 'deficits don't matter' has become a popular mantra, and cast an optimistic gaze on the equity market with a particular focus on tech earnings. Think the 1987 crash is a thing of the past? Let's dive into a fascinating exploration of its echoes in today's market.

Hold onto your hats as we take you through an exciting whirlwind of geopolitical news. You'll learn about Biden and Scholz's potential trips to Israel, how Poland's pro-EU opposition seized power after eight years of populist rule, and why the US is tightening the screws on China's access to advanced semiconductors. Now, let's shift gears to the market. We'll discuss Rite Aid's bankruptcy, Pfizer's Paxlevid agreement, and how tech stocks are giving the S&P 500 a pedal to the metal. Curious about Tesla and Netflix's earnings? Stay tuned!

In our final segment, we dissect the influence of tech giants like Meta and Nvidia on the S&P 500 earnings growth. We'll reveal the potential drags of Exxon Mobile and Pfizer, and how these could sway the overall market performance. Additionally, we'll delve into the traditionally strong period of the S&P 500 from the 197th trading day to the end of the year. Wrapping up, we'll touch on Bank of America's predicament with its large holding of low-yielding mortgage securities, and how investors should be focused on the impact of higher rates when the bank reports their earnings. Join us for a thrilling journey through the twists and turns of the current market.

** For informational and educational purposes only, not intended as investment advice. Views and opinions are subject to change without notice.

For full disclosures, ADVs, and CRS Forms, please visit https://heroldlantern.com/disclosure **

To learn about becoming a Herold & Lantern Investments valued client, please visit https://heroldlantern.com/wealth-advisory-contact-form

Follow and Like Us on Youtube, Facebook, Twitter, and LinkedIn | @HeroldLantern

Transcript

Alan Eppers: 0:00

And now introducing Mr Keith Lanton.

Keith Lanton: 0:05

Hi, good morning, it's Keith. Hope everyone had a enjoyable fall weekend. Here we are it is October 16th, halfway through the month of October already. October, of course, is not the scariest month by traditional measures for the markets that's September but two of the biggest market crashes in the history of the US market did occur in October and that certainly weighs on the mind of investors. The 1987 crash was few days from today, in 1987, on October 19th. So 87 crash does weigh on the mind of those who experienced it many years ago in the emotions that they felt at that time, and some may remember that it was a time that had some similarities to today where Fed was raising interest rates, albeit back in 87, it was at a steeper trajectory than we're currently experiencing. We've already experienced a steep trajectory in the rise in rates and it was a time when there was concern about earnings and real estate and a handful of stocks were largely driving the market's higher. So we do see some similarities, but there are certainly meaningful differences in terms of what's taking place in the market.

Keith Lanton: 1:21

One of the things that was on the minds of investors although not to the same extent is what we're seeing today is the fact that US government was running deficits back in the 80s. A lot of those deficits were attributable to the US's efforts to outspend Russia and win the Cold War, and Ronald Reagan, certainly known as the staunch conservative, was also a proponent of upspending or, if he would put it, investing in America in order to build up our military. And there were certainly concerns back then, as there are today, about deficit spending. But I will say that I think that we have reached a different level of spending today and we're going to talk about that. This morning, brad and I were speaking and we were talking how all of the instability of the world obviously the situation in the Middle East and, of course, the Ukraine, as well as ongoing tensions between the US and China you would think, potentially, that that would cause a flight to safety, perhaps some weakness in futures this morning. And then this morning we are seeing strength in US futures. We're seeing weakness in US bonds and the question is why? And going to talk about perhaps the reason for some of the weakness in the Treasury market. We're going to talk about some of the structural challenges facing the bond market in terms of supply and demand metrics, and then perhaps we'll also focus on what's going on in the equity market. Talk about Barons and how markets are focused on earnings and focus particularly on the tech earnings and maybe somewhat cautiously optimistic about what may be taking place from an earnings perspective, and perhaps that's relating to some of the optimism in the equity market.

Keith Lanton: 3:04

But let's back up. Let's talk about the bond market. We've been talking about deficits and bond market for a few weeks and want to continue on that theme and let's put our government spending and current deficits into context. Us gross domestic product, which is the revenue of the US economy, is approximately $26 trillion. Our tax collection, or the revenue of the federal government, is around $4.8 trillion. So government's bringing in about the 18.5% of GDP as tax revenue, but we are spending about 6.5 to $6.8 trillion this year. At the same time, we're bringing in 4.8 trillion, resulting in a budget deficit of officially about 1.7 trillion, or 6.5% of GDP, but arguably about 300 billion of that is due to some accounting mechanisms where we are no longer forgiving student debt. So we've got a windfall this year which was an expense last year of $300 billion that we're not going to be spending for this student debt. So the number coming in at 1.7 trillion deficit, but the reality is that we really got back 300 billion from last year, so last year's deficit was really closer to about 1 trillion and this year's deficit is closer to 2 trillion. So you can see the trend in a good economy, deficit is going up.

Keith Lanton: 4:35

The average maturity of debt owed by the federal government is around 6 years. Therefore, we have yet to feel the full impact of interest rates going from nearly 0 to 5%. If interest rates were to remain where they are today, our annual interest expense will go from roughly $500 billion today to about 1.6 trillion in 6 years, thus adding roughly another trillion or so to the current one point. Let's call it $7 trillion deficit. So great, stay where they are and our spending stays like it is. We would be looking at, instead of close to a $2 trillion deficit, a $3 trillion deficit just to finance our debt, and therefore that would push our budget deficits into double digits as a percentage of gross domestic product. And then, of course, that doesn't even take into account if, somewhere in the next few years, we have a recession and the government decides to throw a few million or a few trillion dollars at it to try and cure it, while our debt pile will accelerate and even faster rate, and perhaps that's some of the reasons why we are seeing concerns in the bond market. We'll talk about some of the more fundamental reasons the boots on the ground, reasons why perhaps interest rates are going up in. What makes them make a shift or change that trajectory if dynamics were to change. So, again, going back a few years, we go back to 2019-2020.

Keith Lanton: 6:00

This wasn't either a democratic or a Republican theory, but we talked last week about this theory called Modern Monetary Theory. It was all the rage just a few years ago. Modern Monetary Theory argues that if you were the reserve currency, that government spending should not be restrained by rising debt, perhaps justifying some of the significant debt that we were piling on in that time period. Politicians looking for justification and perhaps, as I mentioned in the previous discussion, that when that mindset has become so pervasive, perhaps it's a sign that there's a problem with that mindset. Well, today we have a new mantra that's taken place in the media and that's that deficits don't matter. In fact, dick Cheney said in 2002, I believe the year was that Ronald Reagan approved that deficits don't matter. But now we're saying deficits don't matter. And when will they matter? Well, they don't matter until they do, and who knows? But perhaps right now is the time when, all of a sudden, that it is the time that deficits do matter.

Keith Lanton: 7:02

In fact, last week, many who have followed financial markets for a couple of decades got a new economic statistic to focus on, or a new economic fact, I should say. All of a sudden, financial markets are focused on treasury auctions. Now, if you've been watching markets for many years and you've been gauging economic statistics to look at and economic indicators how treasury auctions go and how successful they are and how much supply and demand are being evidenced that these auctions are typically not something that the markets are all that focused on. But last week we had the government auctioning off long-term treasuries and the treasury auction didn't go so well. And all of a sudden we are once again focused on a new economic statistic. At treasury auctions, the US government sells its debt. The yield is the price that buyers and sellers meet at.

Keith Lanton: 7:56

Until, very recently, there was consistently strong demand relative to supply, and that's because the market had big buyers. Who were they? The Fed was buying quantitative easing, foreign central banks, the Europeans, the Chinese, the Japanese. They were buying, and large US commercial banks were also buying with all the deposits that were being put into those banks, from all that money that was being created and handed out, and these buyers were, by and large, very non-price sensitive. They absorbed a lot of the supply. The remaining marginal buyers competed for a relatively minimal supply.

Keith Lanton: 8:40

Last week, we observed the new phenomena taking place. The Fed not a buyer Foreign central banks, the Chinese, the Japanese, the Europeans have cut back on their purchases for reasons unique to each of those individual purchasers. The US banks are no longer taking in deposits, but are bleeding deposits as rates rise, and they are not raising their deposit rates at the same rate that interest rates are increasing. What is happening is that we are seeing supply relative to demand increasing significantly. We talked about the fact that the deficit is going to be approximately $3 trillion this year.

Keith Lanton: 9:24

All that debt has to get auctioned and, on top of that, the Treasury is constantly auctioning off debt to meet the redemptions of existing debt. So there is this significant increase of supply, and today the marginal buyers are individuals, pensions, hedge funds and corporations, and then not only the marginal buyers, they are in many cases, the primary buyers, and these buyers are generally A not as large as the Fed, the central banks of other countries or the US banks that we're buying and, perhaps more importantly, they are more sensitive to interest rates relative to other investments. Therefore, their demand is significantly more price sensitive. Hence, what do we have going on in the Treasury market? We have increased supply, we have less demand and we have more price sensitive demand buyers. What is that? Equal? That equals lower prices. Lower prices for bonds mean higher yields, and what that means is that there's a lot more importance being placed on what's going on in Treasury auctions, and interest rates have gone up significantly in just the past several months.

Keith Lanton: 10:36

Perhaps you could point to one crucial date over the summer, and that is July 31st, and on that date is the date that the Treasury announced it is going to need to borrow more than $1 trillion in the third quarter of the quarter that just went by Now. That in of itself, is a huge number, but it's even more significant relative to what expectations were before the Fed made that announcement. Before the Fed made that announcement, the expectation was that they were going to need to auction off about $775 billion, not 1 trillion Actually, $725 billion, not 1 trillion. So all of a sudden, on July 31st, the market got the news $275 billion more bonds are coming to market than were expected and we've got to find a home for those bonds and perhaps this supply demand equation that we're talking about here, this new paradigm, is something that we are going to potentially have to live with for quite some time. Let's change gears and let's talk about what's taking place.

Keith Lanton: 11:39

This morning we can talk about the markets, not just the bond market, but the stock market as well. Taking a look at current levels, as I mentioned earlier, we are seeing the equity markets higher. At the same time, we are seeing the bond markets lower. S&p futures right now are about 13 points over fair value. Dow futures are up about 160. Nasdaq futures up modestly about 20 points over fair value. Oil this morning is up about 50 cents a barrel, as I mentioned. Treasury yields higher, prices lower. Two year is up to about a 506 and the 10 year is up about 6 basis points to a 469. Cf futures are positive, reflecting some relief that the weekend did not produce a widening of the Israel Hamas conflict. A potential escalation is certainly on the mind of all of us as Israel prepares to invade Gaza in a few days with tens of thousands of soldiers, according to the New York Times, I ran foreign minister warned Israel that Hezbollah might join the conflict and that it could suffer a large earthquake if it doesn't stop its attacks on Gaza. Separately, the People's Bank of China injected liquidity through the medium term lending facility in a bid to support economic growth, but left their medium term lending facility rate unchanged at around 2.5% In an effort to de-escalate.

Keith Lanton: 13:05

There are significant diplomatic efforts going on in the Middle East. President Biden and German Chancellor Olaf Scholz are both weighing trips to Israel. Meanwhile, us Secretary of State Anthony Blinken is scheduled to return on Monday after meeting Arab leaders to discuss the war and efforts to provide humanitarian assistance to people in Gaza. In the US China arena, the US is planning to tighten sweeping measures to restrict China's access to advanced semiconductors and chip making gear, seeking to prevent its geopolitical rival from obtaining cutting edge technologies that could give it a military edge. The latest rules aim to refine and close loopholes from curbs announced last October In other geopolitical news.

Keith Lanton: 13:51

Poland's pro-EU opposition is going to take over after eight years of rule by populists in Poland and in New Zealand, they also elected a more conservative government, their most conservative government in decades. Cbs News is reporting that the US can't rule out the Iran, which used to get directly engaged in some way in the conflict in the Middle East. And then, of course, here in the US, we have the ongoing situation with the House of Representatives seeking a speaker. Jim Jordan has been nominated to be the speaker, but CNN is reporting that latest indication is that he still lacks the votes for the job. The House is expected to vote tomorrow, but it could take multiple ballots before a winner is announced. In other news, the SEC is not expected to appeal a ruling where an appeals court ruled that grayscale can issue a Bitcoin ETF, so perhaps Bitcoin ETFs will be coming to the market in the near term. Also in the news, we have news that the lithium giant Albomol has abandoned their deal to purchase a competing mine for a $4.2 billion amid opposition. And over the weekend, taylor Swift's Euras is easily the biggest concert film opening ever.

Keith Lanton: 15:18

Individual stocks in the news drug retailer Rite Aid filed for bankruptcy and did get a commitment for some indebtor financing. While they are in bankruptcy, protection Pfizer symbol PFE, guiding their earnings 2023 meaningfully lower after they have amended their US government PaxleVid agreement and where they have announced that there is less demand for COVID vaccines than anticipated. Perhaps some of this has already been anticipated. Pfizer stock had been a poor performer year to date. Stocks down morning but relative to the magnitude of the announcement would have expected to see it down significantly more. So perhaps some of that had been priced in before it officially got announced.

Keith Lanton: 16:05

Lulu Lemon, this morning up over 5%, going to be replacing Activision Blizzard in the S&P 500. The Lantus and Ford announced further furloughing of workers as a result of the UAW strike. The United Health Care this morning is up about 4%. They have to be upgraded to buy from neutral at UBS. Apple a little bit lower this morning. Bloomberg reporting iPhone 15 sales are off to a slow start in China and Manchester United for those football fans, the football with the feet MANU down about 10% this morning after announcing that Xiqia Xi'in Ahmad al-Fani has withdrawn from efforts to purchase Manchester United, leading to some of that pullback there in the stock.

Keith Lanton: 16:57

Moving on to markets and barons, we talked about last week all the tensions in the Middle East, yet the equity market held up fairly well in the face of this uncertainty and the barons are suggesting that financial markets are certainly keeping an eye on the geopolitics and keeping an eye on the Fed. But the barons are suggesting that for the moment, financial markets are most focused on earnings going forward and a little bit on what the Fed is going to do going forward. So, with respect to earnings going forward, barons saying even though last week we got bank earnings and that's the official start of the earnings season, they say that the real, real earnings season gets underway this week when we start to get earnings from the big technology companies. Financials currently make up about 12.7% of the market cap waiting of the S&P 500. And in fact they make up 17.4% of earnings because the multiples and the financials are fairly low. So they're making up an even larger portion of the earnings of the S&P 500 than their market cap. But these days the banks are lesser reflection of the US economy and they are more reflection of monetary and regulatory policy and therefore markets are not necessarily looking to them to be the guide on what's taking place in the economy. So barons saying earnings season really gets started this Wednesday when the first of the large technology-oriented stocks that have driven the S&P 500 this year are set to report, and that is Tesla and Netflix, and that is going to be followed by Alphabet, microsoft, meta and Amazon next week, apple is on November 2nd, nvidia's third quarter doesn't end till October 31st and they won't be reporting until late November. So these magnificent technology stocks punch well above their fundamental weight thanks to their premium valuation multiples. This group makes up roughly 30% of the S&P's market cap, versus about 12%, as we discussed for the financials, and it is expected to contribute 10% of the S&P 500 sales and 16% of their earnings, and hits and misses from these eight stocks could prompt outsize moves in the S&P 500 index.

Keith Lanton: 19:23

Now, a lot of the growth that's expected in the S&P 500 in earnings in this quarter is attributable to the fact that we are expecting growth from the magnificent eight technology companies. Take Meta, which Wall Street analysts expect to report 8 billion in earnings for the third quarter. That would be up 120% from the same period last year. So Meta alone, if it comes through, will contribute a full percentage point to the S&P 500's overall expected earnings growth in the quarter. Nvidia is expected to be responsible for a one and a half percentage point growth in the S&P 500 earnings Not about 6 tenths of 1% alphabet and Microsoft about half a percent each. With growth rates like those, how well the biggest companies on the market do could meaningfully swing overall S&P 500 earnings growth one way or another.

Keith Lanton: 20:18

And you may be thinking to yourself well, what are the detractors? Which companies are expected to be? The companies that come in and have lower earnings and the biggest detractors from earnings in terms of growth rates are expected to be Exxon Mobile. Xom, due to the drop in oil prices from a year ago, that's expected to be a 1.9 percentage point drag. And Pfizer, which we mentioned this morning, which cited lower COVID and COVID injection and COVID sales, expected to be a 1.5% point drag on earnings. And that's before considering the potential impact to investor sentiment from big tech results.

Keith Lanton: 20:55

Any year ago, dominated by macro themes, the enthusiasm around artificial intelligence has been one of the greatest bullish drivers of the stock market. But hype can only go so far. Microsoft, meta and Alphabet will need to show their AI investments are yielding a positive return. The third quarter of 2023 is still early in the AI revolution, but signs of progress will be looked for carefully by investors and maybe necessary to justify many of the huge rallies in the Magnificent Eight that have already taken place this year. So third quarter earnings expected to continue this week, but some could argue that the official kickoff is actually Wednesday, when we do get these tech earnings.

Keith Lanton: 21:38

Take a look at where we are in the calendar and how you might want to think about equities relative to where we are here. On October 16th, the S&P 500 is now entering what historically has been its strongest period of the year. The strongest period of the year begins typically on 197th trading day, and 197th trading day of the year was on Friday of last week, october 13th and extends throughout the year end, from the 197th trading day of the year to the end of the year. Over that period, the S&P 500 has risen 70% of the time, going back to 1953, with an average gain of 6.8% when it has risen Now. Of course, this doesn't say the market can't go down. It has gone down 30% of the time, but odds are least historically in the favor of investors. What's more, there have been 12 periods that saw gains of 10% or more between 197th day and year end and just two periods that experienced double digit declines. Together, that means investors should give the bullish case the benefit of the doubt, bundestag money or demand theirs, or as long as the market is acting at least reasonably well.

Keith Lanton: 22:50

Moving on to individual stock this morning, a bank stock. I know we said that bank stocks don't matter as much as some of the tech stocks, but bank stocks certainly still, of course, are critically important, especially the large banks, the ones that could be arguably deemed too big to fail. So Barron talked about Bank of America VAC, which is going to be reporting earnings in the near term, and they say that Bank America is right now the problem child of big banks, and how it can write its ship. It wasn't long ago that Bank of America seemed poised to catch, if not surpass, its illustrious rival, jp Morgan. Following the financial crisis, ceo Brian Moynihan doubled down on the company's strength, using its large deposit base to build a steady, seemingly boring institution, and it seemed to be working. Following the outbreak of COVID, bank America's stock returned 116% for two years and it April 1st 2022, surpassing JP Morgan's 70% gain. The rising rates have changed all of that. These days, bank of America finds itself as the problem child of big banks. It trades at just 8.2 times earnings, a 15% discount to JP Morgan.

Keith Lanton: 24:01

The concern with Bank America is its large holding of low-yielding mortgage securities, among other bonds, that have caused it to suffer unrealized losses of $105 billion at the end of the second quarter. Those losses are likely to have increased by 10 to $15 billion during the third quarter. It's the one issue that continues to hang over everything at the bank. Bank America says it recognized the portfolio as an issue and it has been addressing it. It says that they have been taking their portfolio and making it smaller. Now $105 billion sounds like a huge number because it is, but analysts are not expecting Bank America to do something dramatic, like default or have a serious crisis of confidence. Nevertheless, it is something that is a concern and is weighing on not only the valuation, but on the growth rate of the bank.

Keith Lanton: 24:55

Bank of America's earnings are expected tomorrow and investors will be focused on the impact of higher rates and the impact of those higher rates on the bank's portfolio. This is a portfolio of unrealized losses. These are securities that the bank is technically quote unquote holding to maturity. Therefore, the bank is not recognizing these losses. Nevertheless, the bank is therefore earning less on these investments than the market currently would bear, and that is certainly a big weight on the stock. Bank of America is expected to report a profit of 83 cents a share, up from 81 cents a year ago. That's growth, but not much compared with, let's say, jp Morgan, which saw earnings grow by 39 percent, wells Fargo, which saw earnings grow 74 percent.

Keith Lanton: 26:29

Barron says and it does look cheap 8.2 times forward earnings, which is just less than a point above its financial crisis era trough of 7.6 times. It's also trading at about 1.03 times tangible book value, slightly above its COVID era trough of 0.96 hit on March 20, 2020. So did a lot of talking about buy market, talked a little about the equity market, going to turn it over to Brad to give us some further insights on markets and what he's seeing out there. Good morning, brad.

Brad Harris: 27:03

Good morning Keith. Good morning everyone. I hope everyone had a great weekend. I'm so happy I didn't write down my thoughts because I just would have had to tear it all up. On Sunday nights I used to always look to see where the equity futures were trading to get an idea of what to expect for the upcoming week. But these days, around 8 pm Sunday nights, 8 pm Eastern time, you get your first glimpse of where treasuries could be heading. I was very surprised last night to see rates slightly higher, meaning prices lower, in conjunction with higher equity futures. Had fully expected the opposite.

Brad Harris: 27:35

With all the turmoil at home and abroad Politics, war, you name it, everything that can be going wrong sort of is at the moment. Going back to economics 101, there are a few thoughts. One, the inflation fear is trumping everything else and the market is demanding higher rates. Two, maybe, as Keith mentioned earlier, we are just losing our biggest buyers of bond, international banks as well as, obviously, the Fed. Third, and only as a possibility, maybe everything is actually okay and we're just stabilizing at new levels of the yield curve. We'll watch all of this. We are in a trading range on bond. It is extremely, extremely volatile In municipals, rightly or wrongly and focused on 15-year 4% bond at a minimum of 4.25% yield to maturity, some as high as even 4.5% yield to maturity.

Brad Harris: 28:32

I find these rates return to be attractive and livable. As an experiment last year I personally bought some inflation index iBonds. I had to hold them for a year. I was intrigued by the 9% rate that everybody was talking about. First of all, I was paying the neck to go to the system and do it, but that's besides the point. By the time I cashed those bonds out they were paying 3.3%. My total return for the year on those bonds was 6.4%. In the 35% bracket. That was 4.16% after tax. I also simultaneously had bought a 15-year 4% munia par, which is obviously now down in price, but it didn't matter. I collected 4% tax-free. Not much of a difference. Pick up 16 base points.

Brad Harris: 29:17

If I had to roll over the iBond, I'd be getting 3.3%. Obviously you wouldn't be rolling that over, you'd be looking for something else. So I know that is an extreme example, but there's always reinvestment risk when you buy a short bond. So that's why I still do like the barbell approach. I don't think that you should be all in on the long end and I don't think that you should be all in on the short end because you never know when things turn. There's so much more to discuss with all the volatility in the market Back to Keith Thanks.

Keith Lanton: 29:45

Thank you, Brad. Yeah, great point Brad makes on the reinvestment risk. And it's even more powerful today, as Brad alluded to, with the fact that rates are so much higher. So your reinvestment risk becomes significantly more magnified if you are not investing and locking in some longer-term rates if rates do drop. Of course, none of us have that crystal ball, which is why Brad's suggestion of a barbell makes a lot of sense to me. Right now we are seeing futures up, even a little bit higher. Dow futures now up a little over 200 points and Charles Schwab has reported earnings. Sehw is the symbol.

Keith Lanton: 30:25

Charles Schwab got a lot of attention last quarter. They're merger with TD, as well as concerns about their treasury portfolio and their exposure to interest rates and their exposure to cash sorting, meaning their clients seeking out higher yields and keeping lower balances and lower yielding products. Schwab this morning addressing some of that. On their call the stock was down about 70 cents. Now it's up about 30 cents. Perhaps some more volatility as some more information comes out on Charles Schwab. Obviously lots of assets held there from lots of different individual market constituents, so we'll see what impact their commentary has on that stock and in the overall market as things progress.

Alan Eppers: 31:12

Thank you for listening to Mr Keith Lanton. This podcast is available on most platforms, including Apple Podcasts, spotify and Pandora. For more information, please visit our website at www. heroldlantern. com.

Sofie Cohen: 31:30

Investments expressed herein are subject to change and not necessarily the opinion of the firm. Past performance is no guarantee of future results. The information presented herein is for informational purposes only and is not intended to provide personal investment advice. It is important that you consider your tolerance for risk and investment goals when making investment decisions. Investing in securities does involve risk and the potential of losing money. The material does not constitute research, investment advice or trade recommendations.