October Market Metrics that Matter

Stocks ended the third quarter on a down note, with the S&P 500 declining -0.71% for the week, marking its fourth consecutive losing week. The index hit its peak for the year back in July, soaring 20% on the back of excitement surrounding artificial intelligence and signs that inflation was subsiding without a significant disruption to economic growth. Investors’ conviction that the Fed was at its peak policy rate and the central bank would be cutting rates by the summer of next year was growing by the day, which provided further support for the Technology sector to lead the market higher.
 
However, that view changed throughout the course of the third quarter as oil prices spiked and the economy continued to expand despite the Fed’s best efforts to slow growth through higher interest rates. Treasury yields soared, especially at the longer-end of the curve, as investors began to price in a higher-for-longer interest rate view with the 10-year Treasury yield rising 78-bps to 4.59% and the 30-year Treasury yield climbing 88-bps to 4.73% during the quarter.
 
Investors are confronting a complicated environment as they try to anticipate the Fed’s next move. Will rates stay elevated for a prolonged period or will the lagged impact of 525 bps of Fed tightening finally cool the economy and bring inflation back to target? We received an important but mixed picture of the inflationary environment with the Fed’s preferred inflation gauge released for August. 
 
The rate of inflation in the U.S. continues to show signs of a gradual slowdown, albeit with a recent interruption caused by a sharp rise in oil prices. When you look at the underlying pricing pressures in the economy without the impact of volatile food and energy prices, inflation has moderated quite a bit in recent months. The Fed’s preferred inflation gauge, Core PCE, rose just 0.1% in August. This marked the smallest monthly rise since November 2020 and continued the trend of modest monthly rises. Through the three months ending in August, core prices rose at an annualized rate of 2.2%, marking the lowest level since 2020 and not too far off the Fed’s 2% target.

Longer-term Treasury yields have continued their climb higher.  Rising interest rates have put equities under stress in recent weeks as rising borrowing costs weigh on a company’s ability to borrow and grow. There are a few reasons why we’ve seen interest rates climb in recent weeks, so let’s discuss a few of them here.
 
First, there have been growing concerns over the U.S. fiscal deficit. Government outlays on things like social security and rising interest expenses are outpacing government revenues, from things such as taxes. And as a result, the U.S. Treasury has been increasing the issuance of debt to fund this mismatch. At the same time, the Federal Reserve has pulled back from its bond-buying program -- a process known as Quantitative Easing -- and is instead undergoing a period of Quantitative Tightening, which has driven down demand for Treasuries and put upward pressure on yields. When taken together, these two things have reduced the demand for Treasuries while increasing the supply, resulting in lower prices, which, in the fixed income world, means higher yields.
 
One more key reason for the move higher in yields has been investors' resetting their interest rate expectations for the years ahead and aligning themselves with the Fed Reserve’s view that rates are likely to stay higher for longer than many had expected just a few months ago. Over the past few months, we’ve received a series of economic datapoints that has shown the U.S. economy has reaccelerated from its pace earlier in the year. So, the Fed may need keep rates elevated to slow economic growth and in turn eventually bring inflation back towards their target.
 
The Federal Reserve and interest rates have been front and center when it comes to what’s been driving recent stock market returns, but we shouldn’t forget that over the long term, stock prices are driven by company fundamentals and a company’s ability to generate earnings.
 
The S&P 500 recently weathered three consecutive quarters of negative earnings growth, but analysts are expecting the index to break free from its earnings recession and deliver positive third quarter results. JPMorgan, Citigroup and Wells Fargo kicked off earnings season last week with all three beating expectations, as these larger financial institutions have generally benefited from the higher interest rate environment. With this strong start, analysts are projecting the S&P 500 to post a positive 0.4% year-over-year growth rate for the quarter, which would mark the first positive rate since Q3 2022. Subsequently, analysts anticipate an acceleration in earnings growth throughout the fourth quarter and into 2024. Here are the projected earnings growth rates for the next three quarters:

• Q4 2023: +7.6%

• Q1 2024: +8.1%

• Q2 2024: +11.7%

Concerningly, though, a meaningful portion of that earnings growth comes from energy companies (from higher oil prices, etc) and financial companies (in the form of higher interest payments), neither of which are a benefit to consumers. 

Investors received an update on the inflationary environment with the release of September's CPI report. The Federal Reserve's efforts to curb inflation have faced challenges in the past two months, as rising energy prices and elevated shelter costs have kept the Consumer Price Index (CPI) at a 3.7% year-over-year level. However, despite persistently high year-over-year readings, short-term inflation indicators have notably eased in recent months. The past four months of Core CPI reports, which the Fed prefers to focus on as it removes the volatile price swings in food and energy, have consistently remained at a month-over-month level of +0.3% or lower (0.2%, 0.2%, 0.3%, and 0.3%, to be precise). In comparison, the monthly rate averaged +0.5% throughout 2022. This signals a significant decrease in the pace of inflation in recent months. In fact, if we annualize the most recent four-month core CPI readings, inflation is running at just 2.79%, well below the 4.1% year-over-year level and not far from the Fed's target.

How the Fed views those numbers in light of everything else will be interesting to watch to see what they signal for further increases, staying put, or ultimately decreasing rates in the year ahead.  There are still plenty of signals of weakening that could result in a recessionary situation into next year if conditions stay restrictive for growth.

Registered Representative offering securities and advisory services offered through Independent Financial Group, LLC (IFG), a Registered Investment Adviser. Member FINRA/SIPC. Phase Four Financial Solutions and IFG are unaffiliated entities.