More than thirty years ago, political strategist James Carville offered a memorable observation about the influence of the bond market:
"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."
- James Carville, 1993
His comment reflected a simple reality. Governments can set priorities, companies can make ambitious plans, and consumers can decide what they would like to buy. Yet the cost of financing in the economy matters a great deal to all, including owners of common stocks. During the third quarter, interest rates rose meaningfully to fresh, 20-year highs. The economy has remained resilient and corporate earnings have supported stocks, but the bond market has become a more demanding participant in the investment equation.
Overall, market activity has continued to reflect growth expectations and a greater appetite for risk, with bonds selling off and less emphasis placed on the defensive investment characteristics we value. This has presented a headwind to our quality-oriented investment approach. The bond market currently appears to be intimidating more consistent, high-quality companies, but not economically sensitive businesses or those closely tied to Artificial Intelligence (AI). A closer look at the forces supporting the economy and the pressures building in the bond market provides useful context for understanding these results and our conviction in our philosophy going forward.
THE COST OF CAPITAL: Interest rates influence nearly every part of the economy. They shape the cost and availability of credit, influencing household purchasing power, corporate investment decisions, and the government’s debt service burden. Higher interest rates raise bond yields and put pressure on existing bond prices. They can also weigh on equities through increased borrowing costs, slower earnings growth, and lower valuation multiples. If interest rates get high enough, they could trigger a recession and/or make bonds more competitive with stocks for investor capital. We are not there yet.
Several forces are contributing to higher yields. Inflation remains above the Federal Reserve’s (Fed) target, while energy prices and the conflict involving Iran complicate the outlook. Large federal deficits require substantial borrowing, and the U.S. now spends over $1 trillion per year on interest expense alone. At the same time, the extraordinary investment in AI infrastructure is adding to the overall demand for credit. Governments and businesses are now competing for capital, and bond investors are demanding higher yields to compensate for persistent inflation, fiscal concerns, and the risks associated with committing capital over longer horizons.
In September, the Fed raised its benchmark interest rate by 25 basis points, or 0.25%, marking its first increase in three years. The Fed directly influences short-term rates, while longer-term yields reflect investors’ expectations for growth, inflation, and the supply of and demand for credit. We do not know precisely where rates will settle, but we believe investment decisions should be made with the expectation that the recent period of unusually low interest rates is behind us for a while.
THE ECONOMY: Despite these pressures in the bond market, the economy continues to demonstrate resiliency and strength. AI investment is supporting business activity, and higher-income households continue to spend. Rising asset values have helped sustain that spending through the wealth effect. Corporate earnings have provided support for equity prices, even as investors question how long the strongest areas of growth can maintain their recent pace. An economy supported heavily by AI spending and affluent consumers can continue to grow, but it is also more exposed to a change in either source of strength, both of which are increasingly related. The effects of higher interest rates develop over time as debt matures, new projects are evaluated, and consumers adjust their spending. Affordability continues to be an issue for many. The question is whether earnings and economic growth can remain strong enough to absorb the higher financing burden. With stock valuations already elevated, any shortfall in earnings or growth could leave markets more vulnerable to a correction.
INVESTMENT RETURNS: In the stock market, the distinction between a sound business and a strongly performing stock can be stark in the short term. Investors have favored companies with faster expected growth and shares that tend to respond more sharply to rising markets and cyclical influences. High beta stocks, those which generally fluctuate more than the market, have substantially outpaced lower volatility stocks. Momentum has also been rewarded. Although leadership has broadened beyond some of the most crowded AI investments, that broadening has not translated into comparable participation by many defensive, higher-quality companies. This is despite the fact that many of these companies have demonstrated attractive fundamental improvement.
Our approach places considerable weight on earnings consistency, financial strength, and the ability to sustain and grow dividends. These characteristics help us evaluate how a business might perform under a range of economic conditions. When investors are increasingly confident in continued growth, however, the resilience afforded by a steadier business can receive less attention and become an overlooked advantage. A company may continue to earn profits and pay dividends without attracting the enthusiasm directed toward those businesses expected to grow faster. Shares can consequently lag even when operations remain sound, which leads to embedded value. We are observing this across a number of the portfolio constituents.
We saw a similar phenomenon unfold 27 years ago in 1999. Then, it was the internet craze that enabled stock averages to make new highs at a time when most companies’ shares were selling off. Similar to today, interest rates were rising at the time, yet growth stocks continued to advance. This is because the discount rate was going up, but earnings were rising even faster. The historical parallel is strikingly similar to what we are experiencing now. In that earlier period, once the earnings growth slowed due to an economic downturn, a long and drawn-out bear market ensued.
These conditions help explain why our emphasis on quality and downside protection is both an important portfolio safeguard, but also a factor that has constrained participation of late. We cannot predict when the market will place greater value on the characteristics we favor, and a change in leadership need not depend on a recession. Our objective remains to populate the portfolio with the highest-quality companies, knowing that over time they will participate meaningfully in rising markets while limiting the damage that declining markets can do to long-term compounding. We remain committed to a disciplined approach that weighs each investment’s return potential against the risks assumed to achieve it. This philosophy has guided our firm for decades, and our conviction in its long-term merits remains fully intact.
Carville’s observation reminds us that the cost of capital eventually deserves everyone’s attention. We believe the same is true of the durability of earnings and the price paid for them. Those considerations continue to guide our work on behalf of our clients.
Crawford Investment Counsel Inc. (“Crawford”) is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Crawford’s investment advisory services can be found in our ADV Part 2 and/or Form CRS, which is available upon request. The opinions expressed are those of Crawford Investment Counsel as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed. Past performance is not indicative of future results. There is no guarantee of the future performance of any Crawford portfolio. All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met.
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