Powell in Charge
• Equity returns for August and September are typically negative.
• This year these returns are further impacted by Fed monetary tightening.
• So far, Fed policy decisions have led to five rate increases this year; the last three hikes have been 75 basis points each.
• Inflationary pressures have been further exacerbated by persistently high food and energy prices.
• Higher interest rates and lean housing inventories have slowed the housing markets but have had minor impact on the job markets.
• Although investor mood has turned decidedly negative, this change often serves as a signal for positive returns over the following six-to-12-month periods.
September has lived up to its market history while worsening a trend that began in early January. Since 1950, this late summer month has traditionally been relatively unpleasant for investors, with S&P 500 performances falling an average of -0.50% in September. August has historically not fallen far behind either; investor returns are also generally negative, off by an average of -0.30% for the month.
Unfortunately, this year will likely skew those averages a bit. Investors now face a rather determined Central Bank that is resolved to continue ratcheting up interest rates as Fed Chair Jerome Powell tries to play catch-up with a post-pandemic inflation spiral.
Returns as of this writing (September 23) were as underwhelming as expected and also “average-skewing.” The prior one month price level returns for the S&P 500 have fallen -10.4% and, on a year-to-date basis, -22.5%. The more tech centric Nasdaq composite was less forgiving, down -12.5% and -30.5% for comparable periods. Unrecognized by many investors and market watchers, the bear market routing had already begun earlier in the year following the benchmark’s peak on
January 3 at a level of 4796. Despite a few interim bear rallies, the S&P continued its slide through this past Friday to an index level of 3693, just shy of the earlier June 16 low of 3666.
The underpinning of this market reversal was the acceleration of monetary policy tightening, resulting from the Fed’s efforts to reverse inflationary pressures caused by the post-pandemic recovery. Although some relief is already visible—including a step-back in gasoline prices which are down from a record average of $5.02 to $3.68 last week, and a loosening in supply chains back to 2016 delivery levels—core inflation is still a sizeable economic and market headwind.
Through this month, headline inflation (including food and energy) still sits at a year-over-year 8.3% increase versus June’s 8.5% and May’s 9.1%. Even when we back out August’s energy inflation component of 23.8% and food of 11.4%, a still-elevated core inflation increase of 6.3% remains a target for investors, consumers and, most certainly, Fed policymakers.
Of course, inflation is not unique to the U.S. nor is central bank intervention. This month, Canada raised its interbank lending rate by 50 basis points (one-half percent), to its highest level in 14 years, while the United Kingdom increased rates in tandem, trying to reign in a feared inflation peak of 11%. Others joining in the rate hike chorus included Australia, New Zealand, the ECB and a number of Asian central banks.
Here, the Fed’s September 21 interest rate response represented its third consecutive 75-basis point hike, pushing up today’s target rate between 3% and 3.25%. Although this target range is the highest since before the 2008 financial crisis, expectations are that by early 2023, Fed Fund rates will be in the 4.5% to 4.75% range. Fed watchers may well still have a bit more “teeth gnashing” ahead.
Stuck in the middle
Although tightening monetary policy conversations were more “transitory” early in the year, the markets were already in a state of flux, repricing the risks embedded in rising rates. Just before the first 25-basis point increase in March, the S&P 500 had already forecasted trouble ahead by dropping nearly 12.5%.
The risk of rising rates on mortgage and consumer credit were certainly in the cards but not a top-of-mind concern for consumers—yet. But as rates have risen over the past several months, their impact on consumers has risen as well. The most recent data from the Federal Reserve Bank of New York noted that total household debt increased in the second quarter, adding $312 billion to the consumer debt load of $16.5 trillion. Meanwhile, credit card interest rates have already risen in response to the Fed’s previous rate hikes, with rates now averaging more than 21%.
In the housing industry, three primary factors support the strength of the underlying markets—availability, affordability and interest rates. At the beginning of January, a 30-year mortgage was priced at 3.58%. By March, the rate had risen to 4.67%. Today, mortgage loan costs are pushing toward 6.5%, rates last seen at the peak of the Great Recession in October 2008. Though today’s economic backdrop for the housing markets is not comparable to the subprime mortgage crisis of 2008, the home construction industry is cooling off and further dampening future housing availability.
Of course, higher mortgage rates are adding to the affordability issue for new homeowners, as is the lack of availability. With rates on the rise, many homeowners are not interested in moving again, especially after they locked in last year’s+/- 3% mortgages. Because more homeowners are choosing to stay where they are, housing turnover and inventory levels continue to fall; both contribute to further exacerbating pricing pressures and declining housing availability.
In contrast, however, to rising rates that are hampering demand, housing prices remain sticky for now. According to August data, median house prices were up by 7.7% from last year. So, home prices are up while building permits for future construction are on the decline, serving as a reminder that in today’s environment the housing issue is not a function of either overbuilding or credit-stretched buyers, but rather continuing pent-up demand for housing.
This conundrum in the housing markets has the Fed navigating a unique situation in reigning in housing prices through higher mortgage rates, especially in an environment where prices are primarily inventory dependent.
This situation has some similarities to the job markets. Today’s unemployment level of 3.7% sits below a 74-year average of 5.5%. Meanwhile, job vacancies (as of July) total approximately 11.2 million, offset by 5.5 million actively looking for a job. Today’s nonfarm employment is 240,000 higher than its pre-pandemic levels. At the same time, rising rates have already resulted in some companies trimming back their workforce and existing job openings. So, the net decrease in the labor pool is in the backdrop of a still supply-constrained labor market. As a consequence, the labor markets are tight, and the Fed’s success in bringing the unemployment levels up to a suggested 4.4% may be difficult—or painful—to achieve.
Transitory Markets and Outlook
It would be easy to blame September’s market returns on seasonal pressures, but the real cause has been the Fed’s monetary tightening efforts to reverse several months of heightened inflation. Rising rates have elevated recession uncertainties, pressured corporate earnings, and from a market perspective, created a measure of mayhem with momentum and sentiment indicators.
Ned Davis, a research firm, recently noted that its proprietary Crowd Sentiment Poll has remained in an extreme “pessimism zone” since April 11, now the third-longest pessimistic mood streak since the data began to be collected in 1995. This sentiment level is also reflected in the American Association of Individual Investor’s (AAII) latest investor poll, with respondents reporting their highest “bearish” reading since 2009. The potentially good news though was that when the polls post such negative readings, future returns have generally been above average over the ensuing six and 12 months.
Beyond the negative sentiment polls, market actions are reminders of investors in turmoil. On a year-to-date basis, all but two market sectors—energy and utilities—remain in negative territory. The damage to date is generally widespread throughout the market spectrum, including companies across the range of market capitalizations, international or domestic. Although exceptions exist to the equity market sell-off, these standouts generally represented higher dividends paying companies. For those looking for defensive holdings during this inflationary environment, neither gold nor bitcoin was generally the solution.
Bonds also failed to provide a safe haven for investors as Fed rate hikes hijacked fixed-income security returns, swapping increasing yields for negative performances. Rising interest rates was great news for savers though; bond yield increases have made this staid security look attractive again. Today’s one-year Treasury bonds are now yielding 4.15%, a two-year yielding 4.11% and a 10-year, 3.69%.
One observation on bond yields: shorter maturities today are pushing yields higher than the longer maturity equivalent, reminding us that both markets and investors are nervous about the economy and eager to remain in shorter term investments.
Although the investment environment has been difficult since early this year, we are moving through this economic “repricing” rather quickly with five Fed rate hikes already booked and potentially two more scheduled for November 2 and December 14. So far, despite the best efforts of the Federal Reserve, job markets have stayed healthy, and given the level of demand and inventory, the rate hikes shouldn’t completely derail the housing markets or the economy. The hikes may soften the housing industry up a bit though, providing time to build back inventory and bring prices once again into affordable territory.
In terms of market valuations, asset prices are falling back into reasonable and cheap territory. Price/earnings multiples for the S&P 500 are priced at up to 15.8 times future earnings, now well below their 5- and 10-year averages. And despite the rising rate impact on corporate earnings, analysts still anticipate positive earnings growth of 4.5% for the final quarter of the year, then ramping up to 7.7% in the first quarter of 2023.
Issues still loom ahead that will add more market volatility and investor uncertainty, including future Fed inflation-purge efforts and, of course, upcoming midterm elections. With ongoing geopolitical issues, a war in Ukraine and numerous other distractions, markets must muddle through quite a few “walls of worry.” Still, market opportunities will exist.
Today’s markets are at extreme oversold conditions on a number of metrics including most recent near-term or record lows in S&P advance-decline levels (stocks declining versus advancing), market sentiment (AAII Investor polls), and of course, price/earnings multiples. Even when these markets are painful, history is a reminder that these are exactly the times to buy great value-priced securities and be patient.
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. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.