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September 2022 | Equity Commentary

September 2022 | Equity Commentary

Published on October 10th, 2022

Market Overview

Stocks finished the month of September and the third quarter on a negative note, with the S&P 500 index and the Nasdaq both closing at their lowest levels of 2022. There continues to be a fairly straight line between selling pressure in the equity markets and underappreciated Federal Reserve hawkishness, which Jerome Powell sought to clarify in his Jackson Hole speech, and which has been confirmed many times since by Federal Reserve governors in separate speeches and comments. New, higher projections for the benchmark fed-funds rate by the end of 2022 also dealt a negative surprise to markets, adding to downside volatility for the month. In the fixed income markets, US Treasury bond yields also sold off sharply in September, with the yield on the 2-year Treasury rising to 4.21% and the 10-year finishing the month at 3.80%. The 2-year yield’s steep rise in the first nine months marked its fastest increase to start a year since 1981, and it also further inverted the 10-year/2-year yield curve—historically a recession indicator.1    

As widely expected, every member of the Federal Open Market Committee (FOMC) voted to raise the benchmark fed-funds rate by 75 basis points at the September 20-21 meeting, to a range between 3% and 3.25%. Even though the rate increase was expected, equity markets sold off sharply as investors took stock of the central bank’s new 4.4% projection for fed-funds by the end of the year. This projection was 25 basis points higher than traders were expecting, and it also significantly raised the likelihood of a 75-basis point rate hike at the next FOMC meeting in November.2

US economic growth is moderating, and earnings estimates are coming down, signaling that the Federal Reserve and other global central bank tightening are having at least some effect in reducing demand in the global economy. We believe the issue for the Federal Reserve, however, is that key inflation, labor market, and consumer spending data has held firm even with the backdrop of tightening financial conditions.

In August, the personal-consumption expenditures (PCE) price index – the Federal Reserve’s preferred measure of inflation – rose 0.3% from July and 6.2% year-over-year. The core PCE-price index, which excludes food and energy, rose at an even brisker month-over-month pace, increasing 0.6% from July and also posting a 4.9% year-over-year increase, which was higher than the 4.7% jump registered in July. This data suggests that inflation has become more broad-based, and all but ensures more runway for the Federal Reserve’s rate hike campaign.3

The US labor market and household spending have also been weathering inflation and higher rates, which together have frustrated the Federal Reserve’s efforts. Adjusted for inflation, household spending rose by 0.1% in August, recovering from a decline in July. US consumers are apparently still out spending partly because of ongoing strength in the labor market, where employers added 315,000 new jobs in August. Initial jobless claims, which had slowly started to tick higher earlier in the summer, have fallen over the past few weeks as employers cling to workers in a historically tight labor market. The four-week moving average of initial claims, which helps establish whether layoffs are on the rise in the US economy, also fell.4

One factor that may be working in the Federal Reserve’s favor is the stronger US dollar. The ICE U.S. Dollar Index, which tracks the performance of the dollar against a basket of foreign currencies, has surged over +15% year-to-date through September 30. The dollar has notably reached parity with the euro for the first time since 2002 and has also risen to multidecade highs against the British pound and Japanese yen. Since a strong US dollar lowers the price of imported goods and services while also curbing demand for US exports (and thus potentially slowing economic growth), it can help ease price pressures.5

The Federal Reserve may also benefit from generally tighter financial conditions, signs of which are starting to emerge in the capital markets. The IPO market in the US and abroad has slowed to a trickle compared to 2021, with only 187 offerings in the US raising less than $22 billion year-to-date. In 2021, IPOs raised over $300 billion.6 Banks are also starting to pull back from leveraged loan and junk bond deals, as demand from investors is notably subsiding. Anecdotally, a consortium of banks led by Bank of America and Barclays cancelled a plan to sell $3.9 billion of debt used to finance Apollo Global Management’s purchase of certain assets and operations of Lumen Technologies, after indicating the banks had not received enough indications of interest from investors.7

Overseas, U.K. markets appeared to be jolted by a sweeping plan from incoming prime minister Liz Truss to cut taxes on corporations and the highest income earners, while also implementing new spending. This proposal put the U.K. government firmly at odds with the Bank of England, which has been raising rates since December in an effort to slow growth and halt the surge in prices. Bond and currency markets in the U.K. responded viciously to the policy roll-out, with yields on U.K. gilts surging while the British pound fell to its lowest level ever against the dollar. The Bank of England responded with an emergency intervention in bond markets, announcing plans to purchase £65 billion in gilts over 13 trading days to ease upward pressure on yields (though far less than £5 billion per day has been deployed thus far). Yields on 30-year UK gilts fell from 5% to just below 4%, though they remain higher than before Prime Minister Truss’s announcement.8

We believe that the events highlighted above are but a few indications that financial conditions are indeed becoming very tight globally and combined with recent problems at a well-known Swiss investment bank, are indicating that something may be about to ‘break’ as has happened when conditions have been tight in the past.  As a result, some believe that the Federal Reserve may have to pivot to easier conditions sooner than recent rhetoric has suggested, to avoid an exacerbation of an already problematic environment.  This, combined with a very oversold equity market, could fuel at least a partial reversal of September’s market decline.  As always, we are monitoring the situation and stand ready to change the portfolio’s contours if we deem it necessary.

Sources:

1https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics

2https://www.cnn.com/2022/09/21/economy/fed-rate-hike september#:~:text=The%20median%20federal%20funds%20rate,elevated%20at%202.9%25%20in%202025.

3https://www.bea.gov/news/2022/personal-income-and-outlays-august-2022-and-annual-update#:~:text=From%20the%20preceding%20month%2C%20the,price%20index%20increased%200.6%20percent.

4https://www.wsj.com/articles/inflation-consumer-spending-personal-income-august-2022-11664484435

5https://www.wsj.com/articles/inflation-keeps-the-u-s-from-stepping-in-to-slow-dollars-rapid-rise-11664663619

6https://www.bloomberg.com/news/articles/2022-09-29/ipos-vanish-in-third-quarter-as-market-mayhem-saps-deal-appetite

7https://www.reuters.com/markets/deals/wall-street-banks-set-cancel-39-billion-brightspeed-debt-sale-2022-09-29/

8https://www.wsj.com/articles/u-k-leader-liz-truss-faces-political-backlash-after-sparking-market-turmoil-11664902325?mod=hp_lead_pos6

As of September 30th, 2022

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