Looking for Middle Ground
• September’s Consumer Price Index rose by an annual 3.7% (mirroring the prior month). This increase was still well below the 2022 high of 9.2% but again higher than the Fed’s 2% target.
• The U.S. economy saw much higher Gross Domestic Product (GDP) growth in the third quarter than in the first two quarters of 2023. Real GDP rose at an annual rate of 4.9%, according to the third quarter’s initial estimate.
• At the close of Friday, October 27, 10.33% of the S&P 500 stocks exceeded their 50-day moving average, in contrast to September’s 14.7% and July’s 50-day moving average high of 87%.
• This past week’s U.S. Speaker of the House of Representatives election will not be enough to remove uncertainty from the markets. Congress is expected to operate with some level of competency, and future expectations include some spending constraints and avoidance of another potential shutdown.
An Early Fed Preview
Last month I mentioned that the final quarter of most years tended to be rather bullish. This October, unfortunately, has yet to set the stage for that positive quarter, losing nearly 4% through this past Friday (October 27). Still, looking back at past S&P market data, the months of November and December typically bring investors plenty of “holiday cheer.” This year, however, may require much more than a few Halloween treats to get the party started. An upturn in holiday shopping over the next several weeks would be a good start.
You may also recall that last month the markets were also posting S&P returns of 11%. A month later, index returns had fallen closer to +7%. But again, these returns are still relatively attractive considering the monetary, geopolitical and inflation hurdles investors have contended with throughout 2023. Unfortunately, In the past few weeks, these hurdles have quickly expanded to include a rather messy House Speaker election and the difficult and costly military and humanitarian situation in the Middle East.
And although the likelihood of another interest rate hike is rather remote for the balance of this year, further increases won’t be off the table for several months ahead. The timing, of course, as Fed Chair Powell has mentioned, is dependent on “data” or, perhaps more appropriately, “forecast.” Although bond markets now are actually factoring in rate cuts beginning in mid-2024, there is quite a bit of flux in the economic and market data.
This past week investors watched as 10-year Treasury notes briefly pushed to a 5% yield for the first time in 15 years, and Treasury yields, in general, tightened up within a narrow trading range between 5.57% for a one-month security and 5.03% for a 30-year security. And, in the backdrop of rising rates, the budget deficit has now risen nearly $1 trillion over the past three months to an approximate $33 trillion, a debt-to-GDP ratio of about 98% and growing.
With investors demanding a more calming market environment, it is little wonder that through the one-week period ending October 25, taxable and tax-exempt money markets increased by approximately $26.4 billion. Equity funds, on the other hand, experienced withdrawals of $20.1 billion through a two-week period ending October 18.
The Fed (and Market) Conundrum
While inflation remains above the targeted range, the Fed will not likely remain on the sidelines. Closely watched headline inflation numbers continue to post lower growth rates, but what the Fed is likely looking for is a series of negative CPI reports. Looking at September’s core (excluding the more volatile food and energy costs) and headline CPI reports, the annual inflation growth rates for both were positive, with core inflation up 4.1% and headline inflation up 3.7%. Not surprisingly, the two most volatile components over this past year were both shelter and energy, especially against the backdrop of fuel prices that ranged from $3.20 to $4 per gallon over the past 12 months.
Producer Price Index prices, representing the average change in selling prices received by producers, have however been more volatile. The most recent annual inflation reading of 2.17% ticked up above last month’s 1.95% level, also primarily driven by increasing fuel prices. However, the index is off from its March 2022 high of 11.7% (then representing spiking inventory and resource costs) and up from its June 2023 low of 0.19%. Like both consumer inflation readings, the Fed will be watching for more of a reprieve from rising costs.
Although there is some cause for concern with the slowing incremental changes in the inflation gauges, it appears that the Fed is letting the higher market rate environment (10-year Treasury rates) do some of the necessary work in slowing down the economy. Near-term investor concerns, though, are that if rates don’t hold, the Fed’s reaction will be to implement another interest hike. In the meantime, the offsetting economic risk is that higher market yields pressure the economy (i.e., mortgage yields) and pressure equity valuations.
Although we continue to discuss the likelihood of a soft versus hard economic landing, the initial report for this third quarter’s GDP growth rate was better than already elevated expectations. At a growth rate of 4.9% versus last quarter’s 2.1%, the U.S. economy was exceptionally strong this past quarter. Personal consumption expenditures (consumer spending) were up 4%, while final sales of domestic products (value of U.S goods) were up 3.5%.
Given the unexpected spike in Q3 GDP data, we need to consider that the economic strength for the prior months now reflects stale data. Although the Fed may believe the economic activity was additive to inflationary fears, it is not representative of what is still ahead. Since the third quarter closed, higher rates have continued to work their way through the economic channels.
Second, at this point, the Atlanta Fed GDPNow model is already forecasting a lower annualized Q4 reading of 2.9%. It is still early in the quarter and too early to close out the year’s growth rate. Certainly, a new set of hurdles is ahead, but we are still benefitting from stable/growing labor markets and a still engaged consumer.
Manufacturing on the Cusp
Although the U.S. economy is still relatively fragile, this past month’s report for the Manufacturing Purchasing Manager Index (PMI) moved from contraction to neutral while the Services PMI index remained in expansion territory for its ninth consecutive month. Although the services category fell slightly (0.9%) to a reading of 53.6%, the new orders index expanded in September also for its ninth consecutive month.
Within the service sector, 13 industries reported growth in September, including real estate, retail trade, mining, utilities, health care, transportation and warehousing; and professional, scientific and technical services—all key economic growth employment categories. Regarding the manufacturing sector, the last time that the PMI level was at 49% was the prior high posted in November 2022. Despite the manufacturing sector still falling short of expansion territory, the month-over-month PMI improvement for September is a clear positive.
The Consumer Update
Through all this year’s turbulence, consumers have continued to spend, and companies have continued to hire. And at this moment, there are nearly 50% more job openings than workers to fill them. Also positive is that wages today have moderated while productivity improved by 3.5% through the second quarter. In terms of the number of jobs added to the economy, September’s payroll report posted an increase of 336,000 jobs. Over the past three months, total jobs added and revised upwards averaged monthly gains of 266,000. Wage gains also increased by an annualized 3.4%.
The strength of the labor markets is one of the Fed’s conundrums. Despite rising rates, the labor markets have remained steady. The unemployment rate of 3.8% has fluctuated a bit within a narrow range for the past two years. In terms of job opportunities, data provided by Bespoke Research highlighted that among current national job postings by industry, ArgentFinancial.com 5 Not Investment Advice or an Offer | This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. only seven categories have seen reduced opportunities from the pre-pandemic lows. A few of those categories included software development marketing and media & communications. Those opportunities that have grown above pre-pandemic lows include a number of skilled professions, including surgeons, construction, insurance, legal, production, teaching and others—certainly not a recession-era job market.
With a rise in jobs, improving retail sales is likely to follow—certainly the case with September’s retail sales report. The September reading had increased by 0.7% on a month-over-month basis, well over the forecasted 0.3%. Breadth in sales was also positive, with eight out of 13 sectors showing a monthly increase in sales. Those categories with positive comparisons included online, autos and auto parts, bars and restaurants, health and personal care. The few detractors were sporting goods, furniture, clothing and building materials.
The housing markets also represent another conundrum for the Fed and investors. Rising mortgage rates, now pushing toward 8%, should have softened the real estate pricing frenzy. What it has accomplished is to slow the building of future homes while keeping inventory low enough to sustain higher housing prices. According to HousingWire, as of October 23, there were 554,000 single-family homes on the market. Although there were 57,000 new listings, there are fewer sellers now than in any recent year past. In terms of new homes sold, the median sales price last month was $418,000, while the average sales price topped $503,900. Existing inventory averages about 6.9 months of supply. In terms of existing homes, median sales prices were $392,000, with approximately three months of supply existing on the market.
Still Oversold Markets
At last Friday’s close, the S&P 500 was down 10.25% from its July 28 closing high, pushing the index once again back into the threshold for a 10% correction, the fourth decline of that magnitude since January 2022. And small cap stocks (IWM) have not fared any better, having fallen nearly 18% from its July closing. Looking back to its high in November 2021, small caps are still off by nearly one-third.
Meanwhile, the return variance between September’s best and worst performing S&P sector performance was 52%. This month, the valuation difference between the two sectors—still communications and utilities—is 47% (difference between the former sector’s positive return +32.4% return and the latter’s negative return -14.7%). And as we’ve mentioned in the past, this divergence highlights the extreme valuation differences in disparate companies and sectors.
These return differences become even more apparent when comparing the S&P 500 equal weight portfolio (RSP) with its market cap equivalent (SPY). Since the first of the year, the equal weight S&P 500 portfolio returns were -4.45%, while the momentum market cap portfolio was up 8.74% ̶ a return spread between the two S&P 500 portfolios of 13.29%.
While much of the market weakness has been blamed on higher interest rates and weak earnings, it is still too early to gauge how this past quarter’s earnings releases and forecasts will play out. So far, we’ve seen a few negative surprises, but overall earnings announcements have been reasonably positive. Geopolitical issues have certainly dampened the market, given several unknowns about commodity prices, increasing aid packages and more, all impacting market valuations and earnings expectations.
A deeper dive into the market sectors, investment styles and regional markets highlights similar issues both overseas and here in the U.S.—a broad group of asset classes are in negative territory. As of Friday, October 27, the only positive domestic sectors were consumer discretionary, technology and communication services. With the exception of the 1- to 3-year Treasury market, all maturity ranges are down on a year-to-date basis. One of the more visible dividend strategies, Dow Jones Select Dividend (DVY), was off over the same time frame by more than -12%. A few of the more interesting hiding places, though, were growth-focused strategies such as the Nasdaq 100 (QQQ), S&P Growth (IVW), Bitcoin (GBTC) and Oil (USO). Overseas, Mexico (EWW), Italy (EWI) and Brazil (EWZ) bucked the trend, ending on positive notes through Friday, October 27.
Where do the markets go from here? That is a question that will be partially answered by this month’s FOMC meeting. Quite a few companies are still due to report earnings over the next several weeks, and we may get a few more clues from those reports. In the next four weeks, we will hear from the usual reporting agencies regarding the labor markets, retail sales, housing, inflation and manufacturing levels. The ultimate goal is to convince the Fed in short order that inflation levels are slowing down to acceptable levels.
The hard landing question, though, remains an important one for the markets. If there’s a hard landing ahead, despite the hiatus in rate hikes, it really won’t matter what the Fed does over the near term. Additional market weakness will be the forecast. There are positives, however, including the economic data already discussed—strong labor markets, wage growth and a pickup in productivity. Manufacturing seems to be holding its own, and the service industries are still in expansion territory. The consumer is also still active. These are all measurable trends that we will be watching.
Not Investment Advice or an Offer -This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.