Equity markets managed to finish the first week of the fourth quarter in positive territory thanks to a strong Friday rally. While the S&P 500® Index has still returned roughly 13% year-to-date, it has been driven by a narrow number of names, with many major indexes including the Russell 1000® Value Index, Russell 2000® Index, MSCI Emerging Market Index, and the Bloomberg US Aggregate Bond Index are negative year to date. The weakness has come with greater investor emotion, with four declines of greater than 1% since mid-September and the VIX hitting the highest level since May. Interest rates continue to surge on rapid issuance and foreign government selling to dampen the strength of the dollar, with the 10-year Treasury yield breaking above 4.8% for the first time since 2007. Markets are having a hard time getting traction given the pressure from the bond market, though there are few signs of panic among equity investors.
The “good news is bad news” trend resurfaced following a strong payroll report, driving rates higher and equities temporarily lower before rallying on short covering. Rising bond yields threaten to impact markets in multiple ways, including tightening consumer budgets, pressuring corporate earnings, and diverting investor assets from equities. Financial conditions are tightening, with the banks tightening lending standards and consumer bankruptcies rising to levels only seen in recessions since 1990. Strangely, the market may be doing the Fed’s job for them, as tightening financial conditions could alleviate the need for additional Fed action. Also, tightening financial conditions have historically not been correlated with weak equity markets, with markets rising, on average, 12% over the next 12 months when conditions were at their tightest.
Monthly payrolls shocked investors at 336,000 in September, more than double the estimate and the highest level since January despite higher interest rates, pressure from labor unions, and weak corporate executive sentiment. Strength was seen in leisure and hospitality, government, and health care, while motion picture and sound recording jobs fell due to the labor issues in Hollywood. The rate of unemployment was stable at 3.8%, as was labor force participation. Wages were up 4.2% from a year ago, a slight moderation from 4.3% in August, above the pace of headline inflation, but below core CPI. Economists continue to shift their expectations as data continues to surprise to the upside, given the Citigroup Economic Surprise Index remains above 50. The Atlanta Fed’s GDPNow model continues to project third-quarter growth of 4.9%, well above the consensus of economists at 2.9%. Economists and strategists remain skeptical, however, with a CNBC survey showing that 61% see this year as a bear market rally rather than a new bull market, and 63% expect a recession by the middle of next year.
Risk metrics are beginning to show signs of strain, with high-yield spreads climbing to the highest level since May, the VIX above 17 for more than two weeks, and the MOVE Index (a measure of bond market volatility) touching the highest level since March. CNN’s Fear & Greed Index is in the “extreme fear” category at 22 and the ratio of put option buying versus calls is at the highest level of the year. Companies hitting new lows are outpacing new highs by the most this year, and the S&P 500 is threatening to break below the 200-day moving average for the first time since March.
Events in Israel over the weekend served as a reminder that geopolitical risk remains a threat. Many are concerned about expansion of the scope of the conflict. This is occurring at a time that the House of Representatives is searching for a new permanent Speaker and strained relations among members could delay funds. Crude prices rebounded Monday on supply chain concerns given the conflict.
What to Watch
Inflation data will be back in focus this week as we await the start of earnings season, with PPI being released on Wednesday and CPI on Thursday. Other notable releases include the NFIB Small Business Index on Tuesday and consumer sentiment on Friday. The minutes from the recent FOMC meeting will be released on Wednesday.
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