Key Observations and Outlook
September proved to be a challenging month for the financial markets. Stocks across the board finished lower as there was really no place to hide. While small caps were hit hardest during the quarter, rising interest rates negatively impacted interest-rate sensitive sectors such as Real Estate and Utilities (usually considered to be a safe, low volatility sector), both down approximately 7% for the quarter. After peaking on July 31st, the S&P 500 and Russell 2000 lost ground quickly, falling 6.3% and 10.8%, respectively, through the remainder of the quarter.
Meanwhile, intermediate to longer term bonds also struggled, with the aggregate bond index down roughly 3% during the quarter. Rising longer-term rates, spurred by a re-acceleration in headline inflation numbers, negatively impacted bond returns. However, shorter-term rates remained relatively stable, such that short-term and high yield bonds remained steady for the quarter.
With the S&P 500 up roughly 13% year-to-date, today’s market action is causing many to scratch their head as the results they see in their portfolios don’t seem to line up with what they are seeing in the financial news media. It is important to be able to contextualize what is really happening behind the scenes with the underlying market conditions, which are not as rosy as they seem on the surface:
Oil and Commodity Prices Impact Inflation
While the headline inflation rate continued to ease through June to 3.0%, we saw a modest tick higher in July to 3.2% and then to 3.7% in August, literally fueled by the rising price of oil and core commodities, which increased by 29% and 9% respectively since June 30th. As we suspected in our September note, these items did place upward pressure on the rate of inflation. The Fed is still locked in on achieving a 2.0% inflation rate, so continued progress will be necessary to reduce the probability that the Fed will feel the need to hike rates again. Shelter is the largest component of CPI, making up 43% of the index and had been the stickiest; however, over the last 5 months, we have seen a steep deceleration in real-time apartment rent indices. Along with moderating wage pressures, these should help to offset energy prices over the coming year. Below is a chart demonstrating how the rate of change of oil prices leads the headline rate of inflation. Notice how the blue line, representing the rate of change in oil prices led the decrease in CPI from over 8%. Currently, we are seeing the reverse effect, with oil prices rising.
The Fed Holds Rates Steady
In spite of the reacceleration in headline CPI, the FED decided to leave rates unchanged at the last FOMC policy meeting, leaving some to question whether the FED is truly being “data dependent”, ignoring the recent reacceleration of inflation. As a matter of fact, following the FED’s decision to leave rates unchanged, the market decided on its own that the FED was not doing enough to combat inflation, as the 30-year treasury yield rose from 4.45% to 4.75% between Sept 20th and the end of month. These dynamics indicate that it is the market forces that dictate interest rates across the intermediate to longer end of the Treasury yield curve, not simply the FED.
Treasury Yield Curve Flattens
With the precipitous rise in longer-term rates during the quarter, the Treasury yield curve flattened or de-inverted by roughly 0.70% during the quarter. The chart below measures the constant difference between the 10 year and 2 year Treasury yields, represented by the blue line. When this line is below zero (the green line), that means that 2 year yield is higher than the 10 year yield, which has been the case since July 2022. This “inversion” of the yield curve has been prompted by the FED’s restrictive monetary policy over the last year and a half where the short-term benchmark rate has been increased from near zero to the current level of 5.35%.
Inverted yield curves have been a reliable indicator of a future economic slowdown, as higher short-term rates choke off economic growth. At the Fed’s most recent meeting, Chairman Jerome Powell reiterated yet again the Fed’s resolve and vigilance to slow the economy and contain inflation. This means that short-term rates will remain higher for longer, a fact that the market’s had not previously priced in and a principal reason why rates shot up in the 3rd quarter. The Fed funds rate futures show that the market is now pricing in higher fed funds rate expectations into early 2024.
Leading Economic Indicators Trend Lower
While 3rd quarter economic growth should be positive, the Leading Economic Indicators index (LEI) declined for the 17th consecutive month, signaling the potential risk for recession is rising over the next few quarters. The LEI looks at trends in the leading economic data, such as employment, manufacturing, housing, and financial conditions. The LEI provides an early indication of significant turning points in the business cycle and has historically been leading indicator of recessions. “The US LEI—which tracks where the economy is heading—fell for the seventeenth consecutive month in August, signaling the economic outlook remains highly uncertain” said Justyna Zabinska-La Monica, Senior Manager, Business Cycle Indicators, at The Conference Board.
While the Coincident Economic Index, which tracks where economic activity stands right now, continues to reflect that we are in a favorable, but slowing, environment, the leading index continues to suggest that economic activity is likely to decelerate and descend into mild contraction in the months ahead. Most recent data, including weak manufacturing, higher interest rates, a dip in consumer outlook for business conditions, and moderating labor trends, fueled the LEI’s latest monthly decline. Regarding the consumer outlook, US Retail sales and consumer traffic have been trending lower ahead of the restart of student loan debt repayments. The federal student loan payment pause ended in August, where interest on loans began accruing in September and payments are starting in October, for the first time since March 2020. Although the magnitude of the impact of restarting student loan payments is difficult to predict, it should present an additional headwind to consumer spending.
The Bottom Line
It is important to understand the underlying drivers and components of the market returns. Currently, the “Magnificent Seven” make up 28% of the S&P 500 Index, making it much less diversified that one might expect. There have been other periods in history where this same pattern of performance has occurred in the past, where it did not end well. One might recall the Tech Bubble of 2000, where it took Amazon 10 years, Microsoft 15 years, and Cisco Systems 22 years to exceed their highs from early 2000. Or perhaps the “Nifty Fifty” of 1972, where household names such as Coca Cola, Proctor & Gamble, and Johnson and Johnson reached such extreme valuations that it took years for these companies to recover from the ensuing bear market of 1973-1974. In each of these cases, investors in the stock market chased a small market segment or basket of stocks higher. Investors should not be forced into a basket of stocks like a herd of sheep and nor should investors compare returns from diversified portfolios to a much less-diversified benchmark.
The regional banking crisis from March is like a distant memory and has led most to believe that a real “crisis” and aftermath thereof has been averted. However, not much has changed with respect to regional banks and their balance sheets since that time, and if anything, conditions could be worse. Interest rates are higher and bank lending standards have tightened further, as we continue to see a slowdown in credit availability across most categories of lending. Furthermore, bank deposits have fallen by 12 times more than during the Great Financial Crisis in 2008, as large sums of bank deposits have poured into money market funds. This source of cheap bank funding is simply disappearing from bank balance sheets, which could put additional pressure on margins and capital requirements.
Meanwhile, a government shutdown was averted for a second time, as Congress passed a short-term funding bill as a stop-gap measure, ahead of a critical midnight deadline. This will keep the government open and funded through November 17th, but there is lots more work to be done by Congress to establish a workable federal budget that satisfies both sides of the aisle.
The stock market advance thru July has cooled off with US Large, Small, and Global stocks taking a breather and retrenching over the last couple of months. With the market approaching oversold levels and previously ebullient investor sentiment turning pessimistic, we are approaching a bit of a crossroads, where one path leads toward a potential recession with sticky inflation and further market downside and the other toward a softer economic landing with moderating inflation and the potential for US and Global stock markets to rebound from these levels. At Bison, while we currently maintain a cautious approach toward the equity and fixed-income markets, rather than trying to predict a market outcome, we build our client portfolios to prepare for any market environment, with a focus on accomplishing the long-term goals and objectives of our clients.
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The statements contained herein are based upon the opinions of Bison Wealth, LLC (“Bison”) and the data available at the time of publication and are subject to change at any time without notice. This communication does not constitute investment advice and is for informational purposes only, is not intended to meet the objectives or suitability requirements of any specific individual or account, and does not provide a guarantee that the investment objective of any model will be met. An investor should assess his/her own investment needs based on his/her own financial circumstances and investment objectives. Neither the information nor any opinions expressed herein should be construed as a solicitation or a recommendation by Bison or its affiliates to buy or sell any securities or investments or hire any specific manager. Bison prepared this Update utilizing information from a variety of sources that it believes to be reliable. It is important to remember that there are risks inherent in any investment and that there is no assurance that any investment, asset class, style or index will provide positive performance over time. Diversification and strategic asset allocation do not guarantee a profit or protect against a loss in a declining markets. Past performance is not a guarantee of future results. All investments are subject to risk, including the loss of principal.
Index definitions: “U.S. Large Cap” represented by the S&P 500 Index. “U.S. Small Cap” represented by the S&P 600 Index. “International” represented by the MSCI Europe, Australasia, Far East (EAFE) Net Return Index. “Emerging” represented by the MSCI Emerging Markets Net Return Index. “U.S. Aggregate” represented by the Bloomberg U.S. Aggregate Bond Index. “Treasuries” represented by the Bloomberg U.S. Treasury Bond Index. “Short Term Bond” represented by the Bloomberg 1-5 year gov/credit Index. “U.S. High Yield” represented by the Bloomberg U.S. Corporate High Yield Index. “Real Estate” represented by the Dow Jones REIT Index. “Gold” represented by the LBMA Gold Price Index. “Bitcoin” represented by the Bitcoin Galaxy Index