Markets weakened last week following an extended period of calm, as the hawkish tone adopted by Fed Chair Powell following the FOMC meeting caused the decline. The S&P 500® Index delivered its worst week since March; September is tracking for the worst month of the year. Markets have returned to a “good news is bad news” approach, with strong economic growth driving fears of continued inflation pressure and the need for further Fed tightening. The pullback is notable for the risk-off tone, with weakness in the large technology companies that have driven the rally, along with small caps, consumer discretionary, and industrials.
Interest rates have broken out of a trading range, with the 10-year and 2-year Treasury yields at the highest levels since 2007. Pressure is coming from shifting expectations of Fed policy, continued inflation pressure, and a surge in bond issuance impacting the supply and demand imbalance. The Bloomberg US Aggregate Bond Index is currently negative for an unprecedented third consecutive year. Market interaction is unusual, with simultaneous increases in bond yields, the dollar index, and commodity prices, pressuring earnings from multiple directions. Higher interest rates are putting pressure on equity market valuations through competition for investor assets and greater discounting of future cash flows.
Last week’s skittish reaction to the Federal Reserve’s consistent hawkishness underscores an emotionally charged market sensitive to rate hikes, a strong dollar and squeezed company margins. As we steer towards “Fireworks Friday,” a confluence of three pivotal economic indicators and the kickoff of potential disruptions like student loan resumption and a government shutdown, we may see amplified market Investors should brace for a week that could redefine market sentiment and strategy for the quarter ahead.
Economic data continues to beat expectations, as the Atlanta Fed’s GDPNow model forecasts 4.9% growth in the third quarter and the consensus of economists is nearly 3.0%. The Citigroup Economic Surprise Index remains elevated at 56. Forward-looking data continues to paint a different picture, with the Index of Leading Indicators down from a year ago for the 14th straight month, down 8% in August. Dating back to 1960, every time the index fell more than three straight months, the economy was heading into a recession. On three occasions (1967, 1996, and 2016) negative readings didn’t precede a recession, though the decline was just three, one, and one month, respectively. Anecdotally, FedEx suggested demand was weakening, forecasting revenues to be flat to down, while Darden Restaurants noted weakness in households with incomes above $125,000.
The United Auto Workers expanded their strike on Friday, as there has been little progress in contract negotiations. The union continues to demand a boost in pay of 26%, while the companies are offering a 20% increase over four years. Goldman Sachs forecasts that the strike could impact GDP growth by 0.05-0.1% per week, with inventories likely to run out by Thanksgiving. Simultaneously, the Federal government seems headed for a shutdown at the end of the month. GOP members blocked a procedural vote on defense spending, signaling that the Freedom Caucus is angling for a shutdown. A survey showed that more than half of Americans expect the shutdown to affect them personally, and 68% say the threat decreases their trust in government.
The FOMC voted to keep rates unchanged last week, with the Fed Funds rate remaining at a 22-year high of 5.25-5.50%. Chair Powell’s comments suggested an additional hike is likely, as inflation has “a long way to go” to reach the Fed’s 2% target. Investors aren’t convinced, however, with the Fed Futures curve embedding a 50% chance of a hike by year-end, followed by nearly four cuts over the following eight meetings. The Summary of Economic Projections (“dot plot”) shows stronger economic growth than previously expected, with GDP now expected to grow 2.1% this year (up from 1.0% in June) before slowing to 1.5% in 2024 and 1.8% in 2025. Global central banks have united around a “higher-for-longer” message, including the Federal Reserve, ECB, Bank of England, Turkey, and Taiwan. Bank of Japan, however, voted to keep interest rates and guidance unchanged, while the People’s Bank of China kept rates unchanged following accommodative actions in recent weeks.
What to Watch
A wave of economic data awaits this week, including consumer confidence and new home sales on Tuesday, durable goods on Wednesday, final second-quarter GDP and pending home sales on Thursday, and the PCE deflator, personal income, and personal spending on Friday. The end of the month could add to volatility.
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