By: Stash Graham
Broad financial markets had a strong rally as all three major indices pushed higher during October. The benchmark S&P 500 recovered almost 6% of its year-to-date decline, now down 19% year-to-date. The Nasdaq Composite and the Dow Jones Industrial Average pared losses to 30% and 10%, respectively, for the year. Precious metal gold continued to underwhelm, dropping 2% in October, now down 11% year-to-date. Under pressure during the month, corporate bonds and U.S. Treasuries found some footing towards the end of the month, losing less than 1%. The latter is an important follow, as the Federal Reserve’s preferred recession yield curve (difference between the 3-month and 18-month UST yields) has finally inverted.
Inflation data (October 12th) spooked markets as core and headline CPI prints exceeded expectations. Growth in service-related inflation data overwhelmed goods-related inflation, which showed no growth month-over-month. Services inflation ex-energy drove the core inflation rate higher with a 0.8% month-over-month and 6.7% year-over-year increase. Rent of Primary Residence is higher by 0.88% month-over-month and 7.2% year-over-year, and Owner Equivalent Rent by 0.8% month-over-month and 6.7% year-over-year. Healthcare expenses (including medical care and insurance costs) inflated above historical norms in October. This inflation will likely continue to stick in the coming months, as the Fed has little impact on the sector.
Overall, inflation continues to be elevated. The Federal Reserve will need to keep its foot on the gas pedal to be victorious in its battle against inflation. That said, we see signs that inflation could turn over quickly in early-mid 2023. For example, all regional Federal Reserve manufacturing surveys have begun contracting. Manufacturing only makes up about 11% of the U.S. GDP, but some aspects of the surveys are reliable leading indicators (like new orders). The October ISM Manufacturing survey saw new orders contract for the fourth in five months (49.2- under 50 is contracting). In the September letter, we talked about how raising rates would impair aggregate demand in 2023, we still believe this to be true. The monetary transmission mechanism represents the lag from when the Federal Reserve rate hike is to be made to when they negatively impact the consumer and business. As a reminder, the average time frame from his lag is three to four quarters after the rate hike. The first rate hike was in March, and the material rate hikes were throughout the summer. As a result, we should expect a noticeable decline in aggregate demand (household, government, and business) starting in the Spring. Reducing demand as supply normalizes would dent inflation and the economy.
Although the October market rally was welcomed, we believe another leg lower in markets is forthcoming. First, we have yet to witness enough events consistent with market bottoms. The recent market rally is one to fade and not buy. For example, we have yet to see the Federal Reserve pivot and begin to sound dovish and cut borrowing rates. A dovish and monetarily supportive Fed has happened in every true bear market bottom since the 1960s. Second, we have not seen bond yields rally more than 50 basis points. Except for the 1966 bear market bottom, we had witnessed the bond market stabilize first, and rally before equities made a sustainable multi-year return. This factor will be significant as lower interest rates primarily generated the preceding market rally. Third, we have yet to see a recession declared by the NBER. Finally, while consumer confidence has plunged over the last six months, we have yet to witness a positive turn in future consumer expectations which has preceded market bottoms exceptions in 1966 and 1987.
Midterm elections are days away; the odds of a split Congress are incredibly high. The critical takeaway from this development is that already low odds of growth in fiscal spending declines to non-existent. You could see an increased effort to get future planned deficits down. The chances that the government will provide stimulus checks like President Bush and President Trump’s administrations did are low. With a debt-to-GDP ratio of over 100%, members of Congress could be leery of additional spending. With the rise in interest rates, debt is becoming increasingly expensive. Annualize what the U.S. government paid in interest payments in the 3rd quarter, and it’s now over $700 billion. The odds of a long and drawn-out contraction creep higher with a split Congress.
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