“It is difficult to make forecasts, especially about the future.”
― Sam Goldwyn
As August gave way to September, an Indian summer sun blazed across London and much of northern Europe – a relief after a meteorologically lacklustre ‘high summer’. Markets did not feel this warmth, however. Amidst August’s thin trading, 2023’s narrow-footed, Big Tech-led equity rally had initially marched on, before losing its footing midmonth, then regaining some ground at month’s end. But when markets got back into full swing in September after the summer lull, they set course for what is on track to be the year’s worst month to date. As of yesterday’s close, the S&P 500 was down -4.6% MTD and -6.3% off the July highs. The Nasdaq has felt the sting even more sharply: it is down -5.9% MTD. In a sign of the vulnerability of large parts of the market amidst a remarkably winner-takes-it-all rally YTD, the equal-weighted version of the S&P 500 (i.e., erasing the preponderance of the biggest stocks) turned negative on Tuesday, even as the mainstream market-cap weighted equivalent remains positive at +12.0% YTD as of yesterday’s close. And it is not just US stocks that have suffered in September: the Euro Stoxx 50 was -3.2% and the Nikkei 225 -2.3% lower on the month as of yesterday. Fixed income markets, too, have sold off – generating some of the month’s more striking market action.
The narrative driving this action is a reprise of one now familiar to our readers during this hiking cycle. Investors have been forced to rethink central banks’ likely actions in the coming months and – gasp – entertain the notion that the monetary policy bigwigs really mean what they say: ‘higher for longer’. At their meeting last week, the Federal Open Market Committee chose not to push rates even higher – yet. But this was a ‘hawkish pause’. At the post-FOMC press conference, Fed Chair Powell emphasised the likelihood of another hike at the remaining two meetings before the year is out. Fed policymakers shifted their rate expectations up and out, with a Fed funds peak between 5.5% and 5.75% (i.e., one more +25bp rise) and fewer cuts in 2024 and 2025. They now expect rates to still be above 5% at the end of 2024, up from the 4.6% they projected in June. The context for this changed thinking was visible in the FOMC’s Summary of Economic Projections – the distillation of Committee members’ predictions/projections/guesses (delete according to taste) for key macroeconomic measures. This was tellingly different from the last edition in June. Compared to their June forecasts, Committee members now expect more economic growth, lower inflation and lower peak unemployment ahead. GDP growth forecasts for 2023 and 2024 were revised up to +2.1% and +1.5%, respectively (versus the earlier forecasts of +1.0% and +1.1%); 2023 core CPI is now expected to be 3.7% (rather than 3.9%) and the Fed expects unemployment to peak at 4.1% next year (lower than June’s 4.5% forecast, though higher than the current 3.8% actual reading). The Fed nonetheless still does not expect to reach its 2% inflation target until 2026. In short, the Fed expects a better economy, with no reason to trim rates but rather hold them around their current decadal highs to keep the pressure on inflation.
This message has filtered through markets – with some loud reverberations. US Treasuries (and sovereigns elsewhere) sold off, sending yields to new cycle highs. US 10Y yields have added almost half a percentage point across the month, to stand at 4.61% by Wednesday’s close (a number not seen since September 2007). This is the biggest monthly jump in a year and there have been some dramatic daily moves along the way. Sovereign yields have climbed on this side of the Atlantic too, while higher sovereign yields have echoed along the credit risk spectrum, causing credit spreads to widen. Registering Fed officials’ expectations for the path of rates over the next 12-24 months, futures markets have moved from pricing a December 2024 rate of 4.23% at the end of August to 4.6%. These shifting rates expectations have also seen investors turning back to the greenback. Counter to many predictions at the start of the year that the US dollar could only soften against major counterparts as interest rate differentials narrowed, the DXY US Dollar Index struck a YTD high of 106.7 this week, continuing a remarkably steady ascent since a 2023 low point in mid-July. And as with previous upward adjustments in market expectations for rates during this cycle, this has put downward pressure on equities (especially growthier ones), shaking the year’s rally off its narrow foundations.
However, the sentiment around this latest rate repricing is subtly different. There is more talk of having entered a new rates regime. Deutsche Bank analysts point out that in 233 years of data stretching back to the 1790s, the US 10Y yield averages out at 4.5%. So for all the drama of a remarkably rapid rates reversal (just three years ago 10Y yields were at an all-time intraday low of 0.31%!), we have perhaps merely returned to a (very) long-term norm, truly burying the post-financial crisis era. The structural context of September’s moves bears considering. Market parameters have shifted as the Fed has transitioned from Quantitative Easing to Quantitative Tightening, even as Treasury issuance hits record levels. So far the alarm of some commentators worrying that there would be no buyers has rung hollow, as US households and institutional investors have been happy to buy attractive Treasury yields at a scale sufficient to counterbalance the absent Fed purchases. But the wider effects of these changed market parameters are something we continue to monitor closely.
Meanwhile, the message from September’s US macroeconomic data prints has been inconclusive. Employment data points to ongoing strength, while some housing and consumer sentiment stats point to weakness. It is at least clear that any monetary policy-induced slowdown is not yet truly upon us – as reflected in the Fed’s expectations for Q4 vitality. In Europe, though, the balance of the evidence points more firmly to weakness. In August German factory orders fell at their fastest rate for 30 years (excluding the start of the COVID-19 pandemic) and the September flash composite Purchasing Managers’ Index for the Eurozone as a whole showed orders remained in contractionary territory (with a 47.1 reading). The equivalent number in the UK was even more negative, at 46.8, and trending down. A recession looks more immediately on the cards in Europe than in the US – a point reflected in sterling and the euro plumbing new six-month lows versus the dollar. Inflation remains a key variable on both sides of the Atlantic. US consumer prices ticked higher in August; CPI was +3.6% YoY versus +3.2% the month before, with a +0.6% monthly basis rise. The Eurozone number stood higher in August (at +5.2%) but in September trended firmly down to +4.3% YoY – its lowest level in two years.
An important ingredient in the inflation risk picture is an oil price that has pumped steadily higher since June and is now threatening the $100/barrel threshold, reaching $95.2/bl on Wednesday. Pushed by a hawkish Saudi Arabia and a cash-hungry Russia, OPEC+ (the oil cartel with Moscow attached) has engineered this surge with repeated production cuts in the face of record demand. (This week the Saudi oil minister rather eccentrically claimed Riyadh was not choking off supply in order to ‘jack up prices’. We struggle to imagine the other motives; perhaps the oil kingdom has been converted to leave-it-in-the-ground environmentalists?) Demand, meanwhile, is strong, aided by ongoing economic vigour in the US and elsewhere. The International Energy Agency forecasts global oil consumption to reach a record average of 101.8mn barrels/day this year – and predicts an oil market deficit if the production squeeze is maintained. A higher oil price was the main driver of higher headline inflation in the US in August, via a jump in petrol pump and air fare prices. If the higher oil price holds, it may yet broaden out to give inflation a renewed push up – and the impacts of pricey oil are not only economic. One of the many places where they may make themselves felt politically will be a challenging re-election battle for US President Joe Biden. Having deployed c.300mn barrels from the US Strategic Petroleum Reserve last year after Brent spiked over $110 in the wake of Russia’s invasion of Ukraine, Biden now has less in the tank to counteract the price surge.
September’s stock selloff has been a stinging – if not necessarily unhealthy – correction to markets whipped along in recent months by belief in AI’s new possibilities. But a painful September is hardly unusual; just look at the last three: the S&P 500 was down -3.9% in September 2020, -4.8% in 2021 and -9.3% in 2022. What does this pattern suggest we can expect in Q4? Those last three September reversals were followed up by healthy gains in their respective Q4s: +11.7% (2020), +10.7% (2021) and +7.1% (2022). Heartening though this might be, there is no law of the universe (or, more prosaically, the market) backing a repeat of this pattern. Nonetheless, with the US economy still looking robust to year end, US stocks appear well placed to safely navigate the last quarter of the year. That is, barring a left-tail shock – and the latest, as yet unresolved Congressional tussle to avoid a US Federal government shutdown could yet provide just that, as could another Silicon Valley Bank-style rupture somewhere in the financial system under the weight of existing rate hikes.
With that in mind, the opportunities in fixed income markets look hard to resist. The earnings yield on the S&P 500 is now scarcely outpacing US Treasury yields, meaning investors’ compensation for taking on the inherent risk of equities – the equity risk premium – is now negligible. We are thus happy to selectively lock in rewarding fixed income yields, while keeping our equity exposure steady.
If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch
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