Macro analyst Richard de Chazal breaks down what he believes are the three hurdles to higher for longer, walks through what third-quarter earnings may say about the near-term future, and offers his stance on where the Fed is potentially headed as we move toward a new year.

Podcast Transcript

0:24 - 1:23
Chris Thonis
Hey everybody, it's a crisp fall day here in Chicago. Perfect weather for our latest episode of Monthly Macro with William Blair macro analyst Richard de Chazal. Richard, as always, thanks for joining. We remain lightspeed ahead. October as has gone in rapid fashion and an array of macroeconomic nuances to talk through. I think a good place to start would be the recent volatility in the ten-year yields, which plummeted between October 31st and November 3rd last week. Do you mind breaking down, Richard, maybe why this happened?

There are three hurdles to higher for longer that you say caused some of this recent volatility in your recent weekly market monitor. I think the hurdles were the Treasury's release of its quarterly refunding statement, the FOMC meeting, and the release of the latest employment data. So in other words, it's a bit of a loaded question, but let's get to the impact of each. If you don't mind starting first with that quarterly refunding statement, and then we'll go from there.

1:23 – 10:38
Richard de Chazal
Sure. Hi, Chris. Obviously great to be back and yeah, it's crazy. October has gone by pretty quickly and December is coming down the calendar pretty quickly as well too. But I guess on your question, I might just add a little bit of nuance here in terms of the three hurdles that I wrote about. There aren't necessarily hurdles for higher for longer per say, but perhaps more hurdles for the continued rise in bond yields, as there were.

So, where over the last few months we've seen this huge move upwards in momentum that was rapidly pushing Treasury yields higher, that momentum I think hit a few roadblocks over the last few weeks. And maybe it's a little bit pedantic, but I don't think those hurdles I was referring to really negate per se that higher for longer argument.

But I do think they're really just signaling that there is a pretty good chance that we're now very near to the peak in yield. So I guess in my mind that “higher for longer” doesn't necessarily mean that longer rates will hit 5% or 6% or even higher as some people are talking about, and then just hang out there and not come back down.

But I do think it's possible, or even likely, that in the coming year or so we do see the ten-year yield moving back down as both the economy and inflation slows. But, higher for longer maybe means that the ultimate floor that those yields fall to is not what it used to be. So if you look back at the average yield in the decade, say, between the global financial crisis and the pandemic, so we're talking, say, 2010 to 2019, what we saw over that period was the average ten year yield of 2.3%.

My guess is we don't go back there on a sustained basis but that going forward, that sort of anchor yields for the ten year is going to be something higher. Call it closer to 4%. But I think that's because what I think is changed is that we now have what looks to be greater Treasury bond issuance or supply going forward for the foreseeable future.

And that's being combined with this shift in Treasury buyers away from the price insensitive Fed and other central banks and back towards more sort of price sensitive buyers like U.S. households, pension funds and the foreign private sectors who are actually demanding a higher yield or surprise, surprise, they actually want a higher term premium. They don't want a negative term premium for taking on duration risk.

And that, I think, means that's one area where you could get a bit of a higher yield and then growth obviously and hopefully is a little bit higher because of stronger productivity growth. So again, a little bit more nuanced there when it comes to talking about this higher for longer, and I think that's probably important to mention, but when we've had more recently these three hurdles or roadblocks, I think that has been with respect to the momentum of the ten year yield moving higher.

And as you say, I think the first of those was the Treasury's quarterly refunding announcement, or the QRA, which not many people outside of fixed income markets have really ever paid that much attention to. But suddenly they are. I think as yields have increased and that increase is back in the spotlight, it feels a bit like the Fed's H8 release on the banking system when that suddenly moved back into being in the market spotlight. When the regional banks were failing. But now that's kind of dissipated again.

But I think what the QRA does is it tells the market how much the Treasury borrowed over the last few years. And importantly, it also projects how much it expects to borrow over the coming two quarters. And what we saw in the latest announcement was two things. And the first was that the Treasury actually lowered the estimated amount that it had previously told us in the last report that it was planning on borrowing between now and the end of the year, not by a lot, but the reduction was significant enough to surprise the market and perhaps also viewed as a bit of a signal or a nod from the Treasury that it's actually paying attention to market concerns about oversupply. And then the second thing it did was to play around with the tenors of issuance a little bit. So by that I mean it tilted its estimates a little more towards the short end of the curve. So T-bill issuance rather than longer term coupon debt at the longer end of the curve. So I think that also surprised the market a little bit and helped to support the rally in the ten year.

And then the second thing we saw or the sort of hurdle for this kind of momentum in in yields upwards was the FOMC meeting. And what we saw there was the market interpreting both the FOMC statement and Chair Powell's press conference as effectively, saying we're done on rates. So I think the market saw the introduction of the word financial in the statement as a clear recognition that the Fed was taking into consideration that sharp rise in ten year yields, which had resulted in the tightening of financial conditions, which remember is the channel through which Fed policy impacts the real economy. And that meant that the Fed was being sympathetic to the view that the bond market had already done a lot of the heavy lifting, which in turn reduced the probability of having to do more rate hikes.

So I'm a little bit skeptical on that point because a sharp rally that we've now seen in bonds just sort of undoes a lot of that tightening and kind of I would say ruins a bit the narrative that the market built it up there in the first place. And secondly, I think if you actually listen to Powell, I still think he left the door pretty wide open to the possibility of another rate hike.

I'd agree with the market that the probability of that increase is low. I also don't think it's actually quite as low as the bond market seems to have suggested from that rally. So another thing there, and I think the third hurdle or roadblock to an even higher ten year yield over that quite busy week for macro data was the employment report, which culminated the week on Friday, which finally came in a bit later than had been expected and is also, I think now clearly still you're stating that employment growth, while not actually yet contracting, is starting to decelerate.

And just one last point, if I may, and they're going on a bit long here, but I think we're also hearing that from the corporate sector as well. So I think an example of this, I recently had a discussion with one of our research analysts, Matt Pfau, who covers a lot of the payroll processing companies as well as a lot of the SaaS names. So he's also really attuned to developments in the labor market. But what he mentioned to me and what he actually wrote in his notes, so I'm not telling you anything nonpublic here, is that one of the payroll companies he covers is seeing a very tangible and sequential deceleration in employment growth. And what's interesting is they're also seeing that weakness as very broad based as well in the sense that it wasn't particular to any one geography, size or sector or industry.

And again, he talks about that in his note and that's worth a read. So basically, long story short is I think those factors and probably some short covering as well, really help to pull yields back down more recently.

10:38 – 11:34
Chris T
Got it. So obviously this is this is all impacting bonds and bond yields but I think it would be useful to run through the ways in which these “hurdles” are driving other areas of the market. In particular, I would love to know what’s your thoughts on the small cap cycle, which you put out a note about mid-October. You dedicated this whole, you know, Economics Weekly to it.

It was titled “Where Are We in the small cap cycle?” The conclusion was that there is a strong probability that interest rates have already peaked while, you know, valuations are even more attractively priced across just about all available metrics. You're saying that this suggests that many of the fears investors have been harboring about small cap stocks have already been priced in helping to provide a wider margin of safety and interesting opportunity for more valuation cognizant investors at the higher quality end of the market.

Do you mind do you mind just expanding on that a bit because it does feel like it would be a good segway into that?

11:34 – 19:46
Richard D
Sure. I'd love to. I actually love talking about small caps in a kind of geeky way because I think it's an area that you can really see a lot of macro influences playing out, which isn't necessarily the case with just the larger cap mega-cap stocks, if you will. And what I think we can see is that over time there's a definite pattern with smaller cap stocks, which they tend to follow the economic cycle.

And while there's obviously some exceptions to this and not every cycle is the same, but what we can generally see is that you normally start to see a really powerful smaller cap rally starting typically very early on in the cycle or more specifically right in the midst of an economic recession. And then that rally typically lasts for the next sort of 3 to 4 years before giving way to of larger cap stocks.

Now, why is that? I think it's because smaller caps tend to be more domestically focused than the larger cap stocks. And by that I mean their business models are more local, their revenue streams are more tied to the domestic economy's growth compared to the larger caps, who tend to have larger or wider revenue streams across more sort of diverse lines of business and geographies.

And I think the second major reason is that smaller caps tend to be more sensitive to the domestic credit cycle than larger cap stocks. So whereas the larger caps have access to credit pretty much whenever they want, you know, they've got savings, they have bank lines of credit they can drawdown from, they can tap into global capital markets, smaller caps aren't quite so fortunate.

So what typically happens is late in the economic cycle when interest rates start to rise, when that credit spigot starts to get turned off, when domestic growth opportunities or at least the initial surge in that growth is kind of done, investors start looking to the larger cap companies who can then generate sort of continue further growth farther afield.

And I think given that smaller caps also tend to be more volatile, investors also start to think, you know, if the economy is getting a bit long in the tooth, maybe it's a bit better to tilt towards these sort of less volatile, larger cap companies. So from that perspective, it's probably helpful to think of smaller cap companies as kind of the speedboats of the equity world in comparison to the kind of larger cap super tankers, which means that they can kind of turn quickly when the cycle turns and they're really the most sensitive to the green shoots of the economic recovery as it starts to feed through. But then the slower sort of lumbering, larger cap supertankers also finally get there in the end and then typically take over as that cycle matures. So again, from a macro perspective, watching the relative performance of the two can often help to give you a pretty good indication of at least where investors think we are in the economic cycle.

So what are we seeing today? Well, I think we've had a few head fakes seen in the smaller caps this year where they've risen a bit and then by the end, they've continued to go back to underperforming the large and that's probably because the economic cycle itself has thrown us a few head fakes as well, where it's really held up extremely well.

But that's also meant that expectations for Fed rate cuts keep getting pushed further back into the future. So without yet obviously dipping into recession, I think investors have been a little bit worried about being caught out by that final drop in smaller cap stocks That typically happens just as you enter a recession. So it feels a little like they're holding back.

Maybe they're cautious, maybe they're watching and waiting. So I think that means that the question really is, is it too early to invest in small caps today before it seems we're really actually in recession? And I think the normal answer would be, yeah, you know, it's too early. But I think unusually this time around, the answer is actually no, in that I think it's pretty interesting this time around, at least it's interesting for investors maybe to start to get a little bit of exposure there.

And I think the main reason for that this time around is valuation. So what we're seeing now in terms of valuations across just about all metrics for smaller caps and that's both in relative and absolute terms, is that they've fallen to levels that are really historically extremely low. And you know, the last time, say, for example, we saw the relative P/E as being anywhere near as cheap as it is today, was back in the late mid to late 1990s, which actually has kind of a similar type set up to what we're seeing today.

So by that, I mean back then, consumer balance sheets were also in pretty good shape, certainly relative to what they would become over the next decade moving into the GFC. And the stock market was also being led by a small handful of Internet tech companies and no one really wanted to touch small caps and it feels a little bit like that today as well.

But what then happened back then was that even before the economic cycle turned and the economy dipped into a recession in 2001, small caps actually started to outperform starting in 1999, so two, almost three years before that recession hit. And then, unusually, they continued to outperform straight through that 2001 recession and back out the other side as if it never happened.

And again, I think that was for a couple of reasons. One is valuations were so cheap, so that margin of safety, that value investors really like to talk about was so large that the risk of at least taking a punt and starting to chip away at some of those names just became too attractive. And secondly, I also think it was kind of a product of the Internet boom itself in the sense that investors were making a lot of excess return on those handful of Internet names and at least for the big institutional investors, they were kind of blowing out their waiting restrictions on those stocks, which means that they had to find other areas to put that money. And again, smaller caps were seen as a good diversifier for those excess funds. So, again, nothing ever plays out exactly the same, particularly in financial markets. But I think it's really interesting area that investors should be starting to look at at the moment.

19:46 – 20:15
Chris T
Great. So I'd love to turn to, we haven't covered this yet, but I think it'd be interesting to cover the latest ISM manufacturing activity, which ended up being significantly lower than anticipated. This is the 12th consecutive month it has been below the 50% expansion contraction line. The core takeaway seems to be slow down. Would you mind just digging into that recent reading a bit? It does thread the needle a bit here in terms of what the narrative is, but I'd love to know your thoughts there.

20:15 - 23:01
Richard D
Yeah, I mean, I think that's the message there that things are still slow, slowing a little bit further in more areas and manufacturing is typically at the forefront of the economic cycle. And yes, this was the 12th consecutive month where the ISM index was below 50%. So that means, you know, it's a diffusion index so more companies were saying that growth was slower this month than in the previous month than there were companies that were saying growth was stronger than in the previous month.

And what's interesting is that we've never had a period previously of more than ten consecutive months of below 50% readings, which hasn't been associated with a recession. And even ten was a bit of a push. So with 12, I think there's clearly a real warning sign there and the second point worth noting is that the weakness was really broad based. So the ISM actually reports the share of industries that are reporting growth and the latest reading was just 2%. So again, that's incredibly low.

The times that it's ever been that low, have been associated with recession. So I think clearly there's been a lot of noise from manufacturing after the COVID or during and after the COVID. And, you know, you had jammed up supply chains and then big swings in inventories. So more recently over the last year or so a lot of the slowdown in manufacturing activity was probably related to inventory, destocking, maybe companies suffering a bit of a whiplash effect with ports reopening and suddenly getting more supplies than they actually needed, that kind of thing. But now I think we've pretty much seen the end of that inventory liquidation and it's starting to feel like there's a handing over of that slowdown baton from inventory destocking to actual growth, the weakness in the economy itself meaning that companies are now holding back on activity because there's so much uncertainty about the economic outlook.

So I guess I'd say that there's still a lot of good things happening in the manufacturing sector in the U.S., but it's definitely not immune to the inherent cyclicality that's embedded in the sector, particularly as higher rates start to start to bite or increasingly bite.

23:01 – 23:25
Chris T
To stay on the same macro uncertainty narrative, I think it would be helpful to walk through what we're seeing and they're in the third quarter earnings thus far. Especially in terms of what it says about the near-term future. So maybe we can start with where EPS are so far and then move into some of your expectations for the coming year, if you don't mind?

23:25 – 23:43
Richard D
Yeah, sure. Again, I think it's one of the one of the pleasures of covering the macro economy and not being a bottom-up stock research analyst is not having to stay up all night writing reports on 20 odd companies you cover that all release their earnings in the space of just a few days so not.

23:43 – 23:44
Chris T
Not for the faint of heart.

23:44 – 24:23
Richard D
Yeah. I certainly I certainly feel for my fellow research analysts but you know glad it's not me. But I think what that also does is, you know, it gives me a little bit more space to look at the earnings season from a top down perspective on what I think we've seen so far with just about all S&P 500 companies having reported, is that earnings growth on the whole has been a little bit better than expected, up around 3.4% compared to what analysts were expecting going into the earnings season, which was for a decline of 1.2%.

So that's the best increase we've seen since Q3 last year. But I think there's three other things to note. The first is that the boost in share price increase that companies might normally get when they turn out a positive surprise on earnings really hasn't been there this time around or it's been below that historical average.

Conversely, the second thing is that investors have been much quicker to punish stocks that have missed on earnings. So again, that's been worse than the historical average. And the third thing is that EPS estimates for the current quarter, so the fourth quarter have also been taken down by analysts. And again, while that's normal, the take down seems to have been greater than what has historically been the case. So effectively, what they've seen in the numbers and probably the guidance that the companies have issued wasn't overly encouraging. And I think taking a bit of a step back to look at the bigger picture, the concern I continue to have is that companies, I think over the last few years have been hoarding labor because they know that this time around the pool of available labor isn't what it used to be, which was deep and wide.

So it's meant that companies this time around have been really reluctant to shed workers as quickly as they might have done during past cycles. Once they've started to get a sense of an economic slowdown. And, you know, that's great. That's not a bad thing. But what's really allowed them to do that without seeing more of a dip in profit margins at a time when the real volume of sales activity has actually been slow or negative.

So real retail sales over the last year or so has been negative. It has been that the companies have had strong pricing power. So there's been inflation and they’ve still been benefiting from really low interest costs. So their net interest expense has been low. Looking forward, my concern would be that if interest costs are starting to rise and there's no offsetting price increases with inflation coming down, companies are going to start to look at other ways to gain efficiencies, and, in particular headcount reductions, in order to protect those margins for investors.

So from that perspective, to me, current growth expectations for 2024 of 12% look pretty high. And I think we should expect those to be shaved increasingly in the coming months.

27:29 – 27:43
Chris T
We're pretty much at the end of this one. I wanted to ask one more question and then I'll let you go. Richard, appreciate your time, as always. Any last thoughts just on where the Fed currently stands and is heading as we get close to the end of the year? I think we've covered that specifically yet.

27:43 – 29:02
Richard D
Going back to what we were talking about earlier, I think my fear is that after a pretty good run on inflation coming down quite quickly, the easy inflation gains have kind of been done and we may not see as much or as rapid progress in the coming months. So I think the Fed is worried about that too.

I think what it means is that it's likely to still stay relatively hawkish. It's still adopted this kind of Volker-type mantra, and it's going to have to continue to talk up the possibility of potentially raising rates again, even if ultimately they don't actually do that. But I think the market right now is pricing in just a 9.8% probability of another rate increase in December, a 15% probability of one in January.

So both really low. I wouldn't be surprised to see at least that January number creeping up a little bit higher in the coming months. And again, even if it doesn't ultimately happen, I think that the recent a bond rally means that the Fed has to stay a little bit on edge.

29:03 – 29:11
Chris T
Well, great, Richard, as always, it's been a pleasure. It's a little hard to believe that next month I'll be wishing you a happy holiday season. Hang in there. We'll talk soon. And thanks again.

29:11 – 29:16
Richard D
Appreciate it as always, Chris. Catch up soon.