Markets stabilize as seasonal headwinds shift to tailwinds

Thoughts

• Equity markets have stabilized following a difficult two-month stretch that saw the S&P 500® Index fall by nearly 7%. For the third quarter, the S&P 500® Index returned -3%, the weakest in a year, but still has a 13% year-to-date return. The behavior of the equity market has seen a subtle shift, with greater emotion and volatility in reaction to the Fed, rates, and inflation than at any point this year, with the VIX approaching 20 last week. Sentiment has also collapsed, with the AAII Sentiment Survey showing bulls collapsing to 28% after peaking above 50 in July, while bears are at 41%, nearly doubling in two months. The CNN Fear & Greed Index briefly broke into the “extreme fear” range before closing the week at 26. By comparison, this was in “extreme greed” territory at 82 in mid-July. We now transition to the fourth quarter, where the S&P 500 has been higher 80% of the time by an average of 4.2%, more than double the next-best quarter.
• Bonds have been punished, with the Bloomberg US Aggregate Bond Index down 4% for the quarter and 1% for the year, setting the stage for an unprecedented third-straight annual loss. Upward pressure on rates has come from central bank hawkishness, rising oil prices driving inflation uncertainty, and heavy Treasury issuance. Strong economic data has quelled recession talk, driving the “higher for longer” narrative. Bond market volatility is also elevated, with the MOVE Index at 115, though other classic stress measures in the bond market (TED spread, commercial paper spreads, and credit spreads) are benign.
• While the market is set for a rebound in the 4th quarter, there are three strong signals that investors should be cautious entering 2024. First, economists’ expectations of a recession went from being universally negative to significantly more positive – making it even harder for the market to meet expectations. Second, consumer spending power is likely to run out of steam, especially given how consumer credit card usage has increased. Finally, we are seeing margin pressure driven by rising wages and higher costs for companies, which is exacerbated by a strong dollar and high interest rates. While in today’s market, the path of least resistance is to buy the big tech stocks, if I had $100,000 sitting on the sidelines and were choosing what to invest in next year, I would get creative with value, small cap and international indexes. Next year will likely be a good one for active managers.

News

• Investors were surprised over the weekend when Congress reached a deal to extend government funding for six weeks, though there is no clear indication that a longer-term deal will be reached by November 17. The stress from the looming shutdown impacted debt markets more than equity, as pre-funding of Treasuries drove a surge in the 10-year Treasury yield by nearly 0.5% in September. However, the announcement did not allay those fears with the 10-year yield jumping a further 0.05% on Monday. Among the benefits of the government remaining open is that economic data will continue to be published as scheduled.
• There is good news and bad news on the inflation front, with the core PCE deflator rising at the slowest pace since late 2020 at just 0.1%, though the headline number of 0.4% reflects a surge in energy prices. Compared with a year ago, the core PCE deflator broke below 4% for the first time since June 2021, while headline PCE has been higher for the past two months at 3.5% but is less than half the peak level from June 2022. Personal spending has slowed, rising a disappointing 0.4% in August, though remains a healthy 5.8% versus a year ago. Personal income also rose 0.4% sequentially and 4.8% from a year ago, reflecting healthy real income growth. This is supportive of consumer spending but is a headwind to corporate profits and pricing pressure.
• The end of the third quarter sets the stage for earnings season, which unofficially begins in the middle of October. The current consensus is for fractional growth, which would break a three-quarter losing streak. Sales are expected to increase by 2% (11th straight quarter of positive revenue growth), resulting in another quarter of negative operating leverage. The strongest growth is expected to be in communication services, consumer discretionary, and utilities, with sharp energy, materials, and health care declines. Investors will be watching closely the tone of management on the health of the consumer and confidence in profit margins. This is a critical quarter, as it tends to be the time that investors begin focusing more on the following year than the current one, and significant unknowns will likely result in uncertainty and caution.

What to Watch

• This week’s data will be focused on the jobs market, with JOLTS job openings on Tuesday, the ADP Employment Survey on Wednesday, and the monthly payroll report on Friday. Other notable releases include PMI and ISM manufacturing data on Monday, services and composite data on Wednesday, and consumer credit on Friday.