By: Stash Graham
In August, every major asset lost value. Broad and pronounced selling pressure met stocks, bonds, and commodities. The last time the best performing asset class (high yield bonds losing -1.9%) did worse was in December of 1981. The market used a hawkish Federal Reserve Chairman speech to generate an end-of-the-month sell-off. Predictably all three major equity indices were in the red as interest rate expectations grew while economic growth projections continued to deteriorate. The Nasdaq Composite was down -4.64% for the month. The Dow Jones Industrial Average and the S&P 500 Index were down -4.06% and -4.24%. Year-to-Date, the Nasdaq Composite, S&P 500, and Dow Jones Industrial Average have lost -24.5%, -17%, and -13.29%, respectively. Precious metal gold continues to come under pressure, losing -3% in August. The widely-held iShares Investment Grade Corporate Bond ETF (Ticker: LQD) fell by -4.66% marking another month where conservative investments like bonds succumbed to downside pressure.
On the 26th, Fed Chair Jerome Powell spoke to the public during his annual get-together with business leaders in Jackson Hole, Wyoming. The significant takeaway from the short speech was that the Fed is committed to keeping interest rates higher for longer in its fight against inflation. We witnessed headline inflation pull back during July, and we expect August headline inflation figures to fall again; however, the battle against inflation has not been conquered yet. We have warned about core inflation for a few months; housing-related inflation components continue to contribute positively to the inflation indices while other subcomponents provide negative contributions (i.e., energy, etc.). Housing-related inflation tends to linger around for longer compared to other inflation components. As we enter 2023, we expect core inflation levels to be around 4.5% which is more than two times the Fed’s long-run target. Stepping back and reviewing the significant runs higher in the stock market over the last cycle, whether right after the Great Financial Crisis or the COVID-19 sell-off, a historically loose monetary policy was the major tailwind. Earnings growth was a secondary consideration. We are witnessing the Central Bank take corrective actions to undo some of its ultra-loose monetary policy. Should we expect financial assets to move higher broadly in the face of this material headwind?
With rising labor and debt servicing expenses, S&P 500 earnings growth is starting to turn negative. In the face of development, we need to witness an expansion in valuation multiples for a chance to generate a positive return in financial markets. Unfortunately, for market participants, the chief event responsible for expanding valuation multiples is the growth of liquidity of money and equivalents. The Federal Reserve has shown that the Central Bank has no interest in providing a looser monetary policy for the better part of this year. While interest rate hikes could be closer to the end than the beginning, Quantitative Tightening has just started and will look to accelerate soon.
The previous month produced mixed economic data. Total nominal spending only grew 0.1% for July, missing analyst expectations of 0.5% growth. As a result, there are concerns that third-quarter Gross Domestic Product (GDP) growth levels will be very subdued. On a positive note, real personal income grew 0.4% month-over-month. As this is one of the indicators that the National Bureau of Economic Research uses to define when a Recession starts, we can forecast that the solid inflation-adjusted income numbers will prevent an immediate recession. Finally, the Fed’s July senior loan officer survey indicates a significant slowdown in U.S. bank lending during the end of the year’s second half and into 2023. 52% of senior loan officers expect tightening standards for C&I loans (Construction and Industrial). Credit is the lifeline of the American economy, and reducing the amount of debt to fund businesses can put intense pressure on capital structures.
August should have reminded market participants how serious the Federal Reserve is when they say they want to get the excess out of markets. The fall and winter will hurt the consumption of services like travel and entertainment as this is the seasonal norm. Will consumers gravitate back to spending money on goods after a historic rise in goods-related consumption immediately after the COVID-19 lockdown? The U.S. economy will need that type of consumption to keep the economy afloat. Therefore, we remain cautious on financial assets as long as the Federal Reserve sponsors and maintains a significant headwind (tighter monetary policy).
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