Economic & Market Perspective: October 2023
Investors began the third quarter with optimism, hoping the U.S. Federal Reserve (Fed) could engineer a smooth economic slowdown and shift away from raising interest rates and tightening monetary policy. However, this enthusiasm faded in August and September as the likelihood of a prolonged period with interest rates “higher for longer” became more apparent. Long-term U.S. bond yields experienced their most significant quarterly surge since 2009, while the S&P 500® Index recorded its first three-month loss since September 2022. Fed officials maintained a cautious stance, even as data indicated that inflation was moderating, which helped alleviate concerns about a rate hike in September. However, stock markets declined during the third quarter, highlighting the central bank’s delicate balancing act of combating inflation while avoiding a recession.
Meanwhile, West Texas Intermediate (WTI) crude oil saw a nearly 30% increase in the quarter, marking its most substantial three-month gain since March 2022 and raising worries about an inflation resurgence. In addition, labor disputes persisted as the United Auto Workers continued their strikes, disrupting production by the Big 3 U.S. automakers. More than 75,000 nurses, pharmacists and other employees of Kaiser Permanente staged a three-day walkout in what was the largest U.S. healthcare strike on record before reaching a tentative contract agreement in early October. Finally, the looming possibility of a U.S. government shutdown added to the economic uncertainty surrounding the world’s largest economy.
Equities Step Back, but Still Strong
On the whole, the stock market has enjoyed a strong year, although it experienced a partial setback in the third quarter, erasing some of its gains from the first half. Nevertheless, the S&P 500 Index has delivered a 13% year-to-date return. Following a notable 5% dip in September, the S&P 500 ended up declining by 3.3% in the third quarter, primarily due to rising interest rates. September’s performance was in line with historical trends, as it has been a traditionally weak month for the market. Since 1936, September has typically shown flat average returns and has been positive only 55% of the time, compared to an average of 64% for the other 11 months. With this historically weaker period in the rearview mirror, the markets have entered one of the strongest periods. Historically, in the fourth quarter, the S&P 500 has yielded positive returns 81% of the time, with an average total return of 4.8%.
Both the Russell 1000® Growth and Russell 1000® Value indexes experienced approximately a 3.1% decline for the quarter. However, in the year-to-date perspective, growth stocks still maintain a significant lead of 23% over value stocks. Despite a challenging quarter, the Nasdaq Composite maintained a robust year-to-date return of 27.1%, outperforming both the S&P 500 and Russell 1000, each of which delivered returns of approximately 13%. Even the previously dominant “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) took a step back. On the other hand, small-cap companies, as represented by the Russell 2000® Small Cap Index, dropped 6% in the quarter, resulting in a year-to-date return of 2.5%.
Consistent with our earlier observations, the market has exhibited a remarkable level of concentration, with a handful of companies primarily involved in artificial intelligence (AI) and other technology themes driving returns throughout the year. This concentration resulted in the 10 largest stocks in the S&P 500 accounting for approximately 32% of the index’s value by the end of the quarter. As a result, this prompted investors to consider the potential risks associated with such extreme market concentration. While these leading companies have displayed impressive earnings growth, they appear to be trading at high valuations compared to the broader market. Entering October, the forward price-to-earnings multiple for the top-10 stocks stood at 25.9x, which is 45% higher than the rest of the market’s multiple of 17.8x. This trend likely explains why actively managed U.S. equity strategies have generally lagged behind broad market indexes over the past decade. Many active managers have chosen not to invest in these expensive stocks or construct portfolios heavily weighted in a single industry. These elevated valuations also suggest that the market will require robust earnings performance in upcoming quarters to sustain these levels.
Bonds Continue Historic Struggle
In the third quarter, the U.S. bond market experienced a 3.2% drop as yields increased. It’s important to note that when yields rise, bond prices tend to decrease. During the quarter, the 10-year Treasury yield surged by 60 basis points, surpassing 4.5% for the first time since November 2007, just prior to the Great Recession. Additionally, the U.S. yield curve displayed less inversion following the Fed’s September meeting, with the 2-year Treasury yield standing approximately 47 basis points higher than the 10-year Treasury. To put this in perspective, the spread was 55 basis points at the end of 2022.
Looking at this year through September, the Bloomberg U.S. Aggregate Index declined 1.2%. Unless there’s a substantial rally in the fourth quarter, major bond indexes are heading toward their third consecutive year of decline, a historical trend not witnessed in the United States since its founding in 1776. It is safe to say that when a statistic that stood for 247 years is broken, we should take notice. In the present case, it is important to keep in mind the magnitude and speed of interest rate increases that were necessary to combat the surge in inflation since early 2022—11 rate hikes in 18 months.
Strong GDP Pushes Out Recession
With the final three months of the year upon us, most recession predictions for the U.S. have been pushed back to 2024. Despite factors like the Fed’s tightening measures, challenges in the regional banking sector, a sluggish housing market, and an uncertain fiscal and political landscape, the Gross Domestic Product (GDP) growth has remained close to its expected trajectory and is far from dipping into negative territory.
After 2.2% growth in the first quarter of 2023 and 2.1% in the second quarter, it looks like the third quarter is shaping up to be even more robust, likely coming in at around 2.5%. Consumers have been resilient and, for the most part, remain financially secure, holding jobs with increasing wages and continuing to spend. Real Personal Consumption Expenditures, adjusted for inflation, maintain strong year-over-year growth rates exceeding 2%, with a particular emphasis on the service sector.
Consumer Is Stronger, but Feeling Inflation’s Impact
Consumer spending has served as the linchpin of the robust economy, defying expectations by enduring longer than many economists foresaw. Nevertheless, the future of consumer spending, particularly for the middle class, appears less promising due to the continued elevated prices of essential goods such as food, rent and gasoline, all of which are impacting their discretionary budgets. The middle class is feeling the brunt of this impact. Concurrently, the savings rate has dwindled to a mere 3.5%, compounded by the conclusion of the pause on student loan payments. Recent data from the Commerce Department reveals that Americans currently hold approximately $1.3 trillion in surplus savings, but it is anticipated that this excess will gradually diminish during 2024.
Wage and Labor Strength Continue
The labor market is maintaining its robust health, with new job creation consistently outpacing new labor-force entrants and a sustained low level of weekly unemployment claims. September’s jobs report was particularly impressive, showing 336,000 nonfarm payroll jobs, a significant increase from August’s numbers, which surprised economists and the market. Furthermore, the prior month’s data was revised upward. Year-over-year, average hourly earnings remain relatively steady at 4.2%, although it’s worth noting that by the end of 2022, they stood at 4.6%, indicating limited improvement.
The persistence of wage inflation raises the likelihood of a wage-price spiral, where companies may need to raise wages, potentially impacting their profitability. Additionally, the latest Job Openings and Labor Turnover Survey (JOLTS) continues to reveal a substantial number of job openings, hovering around nine million, indicating almost twice as many job openings as there are job seekers. As previously noted in our Midyear Outlook, a tight labor market has the potential to exert pressure on wages, a key driver of inflation, and strong employment numbers will bolster healthy consumer spending.
Fed Actions Closely Watched
The Federal Reserve refrained from raising rates in both the June and September meetings, but did have a 25-basis-point increase in July. The Fed seems to have entered a pattern of tightening during every other meeting, and the likelihood of a rate hike in the November meeting (since there’s none in October) was roughly 50% entering the fourth quarter.
With a government shutdown avoided for the time being, the six-week interval between the September and November meetings should provide enough economic indicators to persuade the Fed to maintain its current stance, particularly as core inflation continues to trend downward toward its 2% target. If the Fed opts to skip the November meeting, it’s probable that the rate-tightening cycle will conclude, though the reduction of its balance sheet will continue. Nevertheless, the most significant market risk as we approach year-end is the potential for further rate hikes, which could result in excessive tightening amid an already decelerating economy.
Manufacturing Is Slowing
The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) is a widely monitored indicator of industrial activity. It is derived from a survey of manufacturing companies nationwide and assesses their sentiment regarding various business indicators. A reading below 50 signifies that companies are reporting contraction instead of expansion. In August, the ISM PMI registered at 47.6, extending its streak to 10 consecutive months below 50, the longest such period since 2007–2009. This prolonged decline in manufacturing could potentially signal that a broader economic slowdown is on the horizon.
Housing Slows and Mortgage Rates Rise
Higher rates have definitely slowed the housing sector, as the average 30-year mortgage rates have risen beyond 7%, surpassing their previous high in October 2022. As context, mortgage rates were at about 3% in 2021, meaning that a “new” monthly mortgage payment has more than doubled in two years.
Despite the elevated mortgage rates, a limited housing supply continues to prevent a significant drop in prices, protecting the housing market from a severe recession. After briefly experiencing slight year-over-year declines, the S&P/Case-Shiller U.S. National Home Price Index rebounded, showing a 1.0% increase in July. With resilient prices and low inventory levels, homebuilders are gradually stepping in as additional suppliers. Building permits and the commencement of single-unit housing projects have exhibited consistent growth throughout the year.
Conversely, multifamily housing project initiations, which performed well in 2022, saw a substantial 41% year-over-year decline in August. Developers may be reassessing the feasibility of new projects due to an influx of supply, a cooling rental market and challenging financing conditions. If this trend continues without improvement in the single-family housing segment, the housing sector might face more difficulties before it can recover.
Cost of Servicing Debt Surging
The increase in interest rates has triggered various consequences, primarily leading to higher borrowing costs, both for companies and governments. This impact is particularly pronounced among companies heavily reliant on financing to sustain their operations, which include a majority of U.S. companies, as well as the U.S. government itself. To illustrate, the U.S. government currently carries a substantial debt of $31 trillion, equivalent to 126% of the nation’s GDP. This situation is compounded by the fact that approximately $7 trillion of this debt matures annually, necessitating its reissue at higher interest rates. As a result, the burden of interest payments has surged significantly.
For context, in 2021, interest payments amounted to $352 billion and by 2022, this figure had escalated to $475 billion. Notably, in June, the Congressional Budget Office (CBO) projected that interest costs would further climb to $640 billion by the end of 2023 due to the elevated short-term rates and inflation expectations. Furthermore, their projections for 2024 indicate that interest payments could reach $745 billion and eventually surge to a staggering $1.4 trillion by 2033. In essence, the heightened interest rates are playing a substantial role in the significant growth of the U.S. national debt.
Corporate Earnings Not as Grim as Initially Expected
As for corporate earnings, the outlook for 2023 doesn’t appear as grim as initially expected at the beginning of the year, and potentially hit a low point in the second quarter with a year-over-year decline of around 9%. This period of “earnings recession” primarily resulted from margin compression, and although nominal revenue growth has slowed from its peak, it still stands strong at nearly 10% year-over-year.
Companies continue to grapple with the effects of last year’s inflation surge, which has impacted their input and labor costs. They seem to be reaching a limit in their ability to pass these costs on to consumers, a promising sign for future inflation trends. Regarding forward earnings estimates for S&P 500 companies, these have started to stabilize, with projections near $220 per share for 2023 and $245 per share for 2024. This suggests near-flat growth for this year, but anticipates double-digit growth for the following year.
Keeping an Eye on Valuation
Equities appear to reflect an expectation of interest rate cuts that is neither consistent with current levels of inflation nor the Fed’s long-standing assertion that rates will be higher for longer. Equities also appear to reflect an expectation that wage inflation will moderate considerably or that companies will be able to increase prices to cover higher costs. With equities trading at a price-to-earnings (PE) multiple of 19.4 times, they are not cheap by historical standards. Another way to think about valuation is to look at the equity risk premium. The equity risk premium is the difference between the earnings yield of the S&P 500 Index and the 10-year Treasury yield, which is a way to gauge the attractiveness of stocks versus bonds. Today, that number stands at or near zero, the lowest in more than two decades, implying that stock investors aren’t being compensated for the additional risk they are taking by owning stocks. In other words, on a risk-adjusted basis, bonds look more attractive than stocks. This is a direct result of the rise in interest rates.
Summary and Outlook
As the third quarter began, investors appeared optimistic that there would be a smooth economic slowdown as the Fed shifted away from raising interest rates. However, that optimism faded as the prospect that rates would remain “higher for longer” became more apparent. Long-term U.S. bond yields surged significantly, and the S&P 500 recorded its first three-month loss since the stretch between July and September of 2022. The Fed maintained a cautious stance, but stock markets declined, highlighting the challenge of balancing efforts to tame inflation and avoid a recession. Labor disputes, like the ongoing strike by the United Auto Workers and a large strike by healthcare workers, added to the economic uncertainty. Despite these various issues, the stock market continued to have a strong year overall, with the S&P 500 delivering a 13% year-to-date return through the end of September, even after a down third quarter.
The concentration of a few companies primarily involved in AI and technology themes continued to drive market returns, but their high valuations raised concerns. Bond markets experienced a drop in the third quarter as yields increased, with the 10-year Treasury yield surpassing 4.5%, potentially leading to the third consecutive year of negative returns in major bond indexes. The U.S. economy’s recession predictions have been pushed back to 2024, mainly due to strong GDP growth and a healthy labor market. However, consumer spending may wane due to rising prices, and a potential wage-price spiral could impact corporate profitability. The Federal Reserve refrained from raising rates in recent meetings, but might face further tightening before the end of 2023. The housing sector has slowed due to higher rates, and the cost of servicing debt is rising, adding to the overall national debt. Corporate earnings have been impacted by wage and cost inflation, but they are stabilizing, and equities face challenges in terms of valuation and attractiveness compared to bonds.
With these key issues in mind, along with others—such as the 2024 U.S. presidential election, the ongoing war between Russia and Ukraine, and the escalating crisis in the Middle East—investors should continue to expect a sustained period of uncertainty in the financial markets and economy.
Stephen Rich is the Chairman and CEO of Mutual of America Capital Management LLC.
Past performance is no guarantee of future results. The index returns discussed above are for illustrative purposes only and do not represent the performance of any investment or group of investments. Indexes are unmanaged and not subject to fees or expenses. The index returns above reflect the reinvestment of distributions. It is not possible to invest directly in an index.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
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