October 20, 2023
Volatility returned to markets in the third quarter, as inflation remained elevated and long-term interest rates climbed further, reaching their highest level since 2007. For the first time this year, stocks declined for two consecutive months in August and September as investors grappled with the idea of inflation and interest rates remaining higher for longer. Despite tighter financial conditions, the US economy continues to show impressive resilience, leading some to believe a “soft landing” is still possible.
What has been the source of this economic strength? Here are a few contributing factors:
Consumer interest rate sensitivity is at an all-time low: According to the American Housing Survey results from 2021, 42% of Americans own their homes free and clear. For those with mortgages, over 90% have an interest rate below 6% and 62% have a rate below 4%. Furthermore, the influx of stimulus from the pandemic allowed many Americans to lower their high-interest credit usage, and consumers entered this year in a strong financial position.
Corporate America has not yet felt the sting of high interest rates on a large scale: Just as many consumers locked in low interest rate mortgages, many corporations issued long-term debt at historically low interest rates. However, a wall of looming debt re-finance and re-issuance is on the horizon, with 2024 and 2025 exhibiting a high $ amount of debt that will be re-issued at higher interest rates, lowering the potential earnings growth of these companies.
Fiscal Stimulus: While the Federal Reserve has been tightening its belt through rate hikes and the shrinking of its balance sheet, the Federal Government’s loose fiscal policy has had positive offsetting effects. Student debt pauses/forgiveness, pandemic related stimulus payments/tax credits, and other government programs injected funds into the economy, the effects of which are still being felt and contributing to economic growth.
Thus far, these conditions have helped the economy withstand the headwinds from tighter monetary policy. History shows that interest rate hikes affect the economy with long and variable lags which have yet to manifest meaningfully. While some consumer data such as rising debt delinquencies and declining cash reserves indicate potential cracks, the overall picture of the economy still points to continued growth and low risk of recession. With this complicated backdrop, the Federal Reserve will be forced to walk a tightrope to achieve their dual mandate of maximum employment and price stability while attempting to engineer a soft landing.
Recent comments by Fed officials reveal a growing consensus that the end of the rate hiking cycle may be near and the FOMC is likely to keep the Federal Funds rate unchanged at its November meeting. Chairman Powell noted that higher long-term yields could reduce the need for further tightening “at the margin,” though he emphasized that it “remains to be seen” whether higher yields would actually substitute for additional rate hikes. Despite this softening in Fed rhetoric, it still appears there is significant reluctance to cut rates prior to the end of 2024 unless the economy weakens more than expected.
The labor market has remained strong, as evidenced by the September payrolls report that blew away expectations with a gain of 336K new jobs and upward revisions to both August and July figures. Improved labor force participation has helped support job growth, having now recovered to pre-pandemic levels for those aged 25-54. The participation rate for those over age 55, however, remains depressed and aging demographics could limit labor supply growth from here. There are some indications that the job market may cool in the coming months. For example, temporary help services payrolls—a leading indicator for overall employment—have fallen substantially from their all-time high, and weekly jobless claims continue to trend above their average from 2022. Despite that, layoff rates remain low relative to their historical average and there are still over 2M more open jobs than unemployed workers seeking to fill them.
The tight labor market has helped to buoy consumer spending, as evidenced by September retail sales, which increased 0.7%, easily beating expectations. Industrial Production also surprised to the upside last month, driven by broad-based gains across nearly every category and continuing the trend of increased industrial activity in the last quarter. Business spending has held up well due to higher spending on manufacturing. This collection of data should lead to above trend GDP growth for the third quarter and keep inflation elevated. The Consumer Price Index (CPI) rose 0.4% in September, above consensus expectations, largely due to higher energy prices and has re-accelerated to an annualized rate of 4.9% in the last three months. Even though the Fed has indicated a pause in rate hikes, it’s clear their fight against inflation is not over.
The emerging conflict in Israel has not yet had a significant impact on markets aside from providing a boost to oil prices. Investors seem more focused on recent economic data, the rise in long-term interest rates, and a potential shift in Fed policy than on speculating how events may unfold in the Middle East. The eventual impact on the broader equity markets is difficult to predict because the risk of a wider conflict involving Iran or other countries in the region is still hard to assess. If the conflict remains contained to Israel and Gaza, while the humanitarian impact will still be devastating, the market impact will likely be limited as Israel contributes only about 0.5% of world gross domestic product and is not a major producer of crude oil.
Despite the recent pullback in stocks, the S&P 500 has seen significant gains this year, primarily driven by mega cap technology stocks rebounding from last year’s selloff. The index now trades above 18 times forward earnings, thereby appearing stretched from a valuation perspective. However, for active managers looking beneath the surface, there are still plenty of attractive opportunities. Energy stocks were the lone bright spot in the third quarter and our equity strategies benefited from an overweight to that sector. We continue to recommend a healthy allocation to equities and favor value-oriented names with a quality bias which have historically performed well during periods of elevated inflation and interest rates. We also see opportunity in bonds given the recent backup in yields. Income producing alternative strategies are another way to capitalize on the higher rate environment.
Investor sentiment has deteriorated with the decline in stocks and rising geopolitical tensions in the Middle East. As a result, we have seen spikes in expected volatility metrics in the options market such as the CBOE Volatility Index (VIX) and the Put/Call Premium ratio. In the past, this has often been followed by above-average stock performance. Furthermore, the fourth quarter of the year is historically the best for stocks, with average gains of 4.2% (as measured by the S&P 500 Index). While we continue to monitor various crosscurrents facing the market and the economy, recent data suggests investors have reason to be optimistic in the months ahead.
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