Third Quarter Disappointment: What’s Next?

Driven by an upsurge in the “Magnificent Seven” tech stocks, the S&P gained 16.9% through Q2 while the rest of the market was essentially flat. Q3 had a promising start in July, only to see equity markets falter in August and September as reflected in Q3 results for the three major U.S. market indexes: the S&P 500 -3.65%, the Dow Jones Industrial Average -2.51% and the NASDAQ composite index -4.1%. We see this as a normal pullback from a significant rally, not signs of a potential crash. What happened?

Inflation persists, prompting the Fed to signal higher rates for longer. This dashed hopes for rate reductions, which fueled the run up, and triggered a sell-off. With fiscal policy driving inflation, and the Fed combating it with record setting (pace and amount) rate hikes apparently to no avail, we have seen a flight to quality—from stocks to treasuries. Yes, inflation is down from 9% to 3.9%, but these are year-over-year growth rates. Prices are compounding at that rate, well above the Fed’s 2% target.

Two key drivers of inflation—energy and wages—are significant headwinds for the Fed’s efforts. Oil prices are up more than 28% to over $90 a barrel due to short supply. This sharp rise reversed the decline in U.S. headline consumer and manufacturing inflation. A 22% increase in third quarter diesel prices will further impact the economy through increased transportation costs.

From the Fed’s perspective, the unemployment rate is stubbornly low. The last report showed that weekly jobless claims fell to the lowest rate since last January. Increased unemployment is a primary indicator to the Fed that its rate hikes are working. The UAW strike offers further perspective on the current labor market. The strike will also negatively impact Q4 GDP growth. Wage pressures are an issue for the Fed, corporate profits, and economic growth generally.

Some argue that the Fed’s rate hikes have already gone too far too fast, as it takes time for rate hikes to have an effect. Higher for longer may not be the right path as there are early signs of an economic slowdown. Here is a colorful (pun intended) perspective on this issue from the Chief Investment officer of Parnassus Investments as presented in their most recent Insights article:

“If Congress has been pushing on the gas pedal to spur growth, the Fed is now pressing down on the brakes. In other words, I don’t think the story has been fully written yet. I believe the push-and-pull dynamic will delay a downturn, but it won’t prevent one. If you’ve ever shaken or pounded a ketchup bottle, you know what I’m talking about. The ketchup doesn’t come out—until too much of it comes out all at once.” [1]

Rising credit costs are taking a toll:

Existing home prices have increased dramatically as homeowners are reluctant to sell and give up their low interest rate mortgages. A comment I heard on my morning commute referenced a recent study that found that home prices in 99% of U.S. counties have risen to the point where homes are out of reach for the average home buyer. Home builders have been active as they try to fill the supply-demand gap. But 7% mortgage rates are a headwind for new home sales. Speaking of real estate, it is fair to say that commercial office space in major cities is in full crisis mode, and getting worse as leases of unoccupied offices expire. People are simply not “going back to the office” post pandemic.

Small to medium-sized businesses are facing loan renewals at increased rates. Banks have pulled back on loans to small businesses. As a result, defaults and bankruptcies are on the rise. Some healthy companies are not borrowing at current rates, which doesn’t bode well for the economy. 

Consumer credit costs will likely dampen discretionary purchases. Many have borrowed with credit cards to buy necessities and will face a mountain of interest costs. Delinquencies are already increasing. 

The Atlanta Fed’s GDPNow model is tracking a Real GDP growth rate of 4.9% for Q3. Others are closer to 4%. In either case a healthy number. The question is sustainability. Consumer spending (“CS”) accounts for 65% to 70% of GDP and has kept the economy moving in the last several months. For many months, CS has been driven by “experiences” such as travel, tourism, live events, and leisure funded largely by COVID stimulus dollars. However, hiring in those sectors declined by 4% in September and hotel room rates have declined by 16%, both suggesting a fall-off in experience spending. While retail sales have increased in dollar terms, they have been down for the last eleven months if you take out inflation driven price increases. Finally, student loan payments will further impact CS.

Industrial spending on new construction was up 228% through July versus the same period last year and was a major contributor to GDP growth. The CHIPS Act spurred that investment. (There’s that fiscal policy “push” again.) Not a repeatable event for the economy.

Corporate earnings growth drives the equity markets. The Wall Street consensus is for relatively flat earnings growth in the coming months.

The above presents many of the roadblocks to corporate profit and economic growth, pointing to a mild recession sometime in mid to late 2024. Another Fed rate hike or hikes may trigger a deeper recession.

What about the markets? The flight to quality continues unabated. Since the end of the pandemic, a trillion dollars has been added to Money Market funds. The yield on 2-year treasuries reached a 17-year high of 5.12% on October 2^nd. The 10-year yield followed suit with a 16-year high of 4.7%. This demand has been fueled by equity market sales. These yields may reflect a temporary dislocation in bond markets, but why not earn a 5% fixed return while keeping powder dry for the next rebound in equities? With the continued short term market volatility, we wouldn’t be surprised to see further weakness in the S&P 500 in the next few weeks.

Though treasury yields at this level may be temporary, when the Fed does reduce rates, intermediate term bonds are likely to offer higher returns than stocks. Investors with 75% percent or more in equities may want to consider taking some risk off the table and buying treasuries. For long term investors with more balanced portfolios, this may not be the time to add to equity positions, but let your diversified portfolio participate in future upswings in stocks and bonds. 

The Fed is trying to navigate to a soft landing, what some are calling the “Goldilocks” scenario: A modest economic slowdown with inflation at its 2% target. The markets were betting on that outcome earlier this year with many thinking that the forecasted recession would not happen. The strong labor market may be too much of a crosswind for that safe landing. This may also be a “be careful what you wish for” outcome with prolonged stagflation—a no growth economy with inflation.

Another possible outcome is the ketchup bottle scenario wherein the Fed’s rate hikes take hold with a vengeance, leading to credit contraction and a deep drop in economic activity. The markets can overreact in a downturn, just as it overreacts on the upside. A deep, but short recession may be the best outcome. Take the medicine and recover with a long-lasting healthy economy and bull market. Keep in mind that the equity markets tend to recover six months before the economy moves out of recession. A long-running recession could trigger deflation and a long-running bear market, the outcome the Fed hopes to avoid.

Thanks to 3EDGE Asset Management for the graphic below. It depicts the economic cycle with 3EDGE’s overlay of how the markets move through the cycle. It appears that we are headed for the Slowing Economy phase of the cycle, the very thing the Fed is trying to bring about.