By: Stash Graham
The stock market had its worst monthly retreat since the COVID sell-off in March 2020. The S&P 500 fell -9.3% on the month. The Nasdaq Composite and Dow Jones Industrial Average fell -10.5% and -8.8%, respectively. As with the month of August’s losses, the primary culprit of the downside pressure was the Federal Reserve and its conviction on raising interest rates to fight inflation. For the first time since 2009, the S&P 500 generated its third straight quarter of losses. The Nasdaq Composite is down more than -32% for the year, the S&P 500 is down almost -25%, and the Dow Jones industrial average has lost just under -21%. Investment grade corporate bonds (ticker: LQD) lost more than -5% on the month, which continues their similar decline to the stock market. Precious metal gold also was a loser in the month, falling more than -3%.
The Federal Reserve led the markets lower with the FOMC unanimously voting for a 75-basis point rate hike, but the surprise that spooked the market was that the Fed plans for additional 75-basis point rate hikes over the next couple of quarters. In a mid-month speech, Fed Chair Jerome Powell recognized that the chances of a soft-landing are meager. While the Federal Reserve will not come out and admit that it will recess the economy, they are committed to fighting inflation and taking rates into a restrictive territory that inhibits economic growth. A “higher rates for longer” policy is challenging for the economy but worse for the stock market’s near-term prospects. Finally, Fed monetary policy has elevated mortgage rates which have curbed demand for home purchases. Lennar executives recently informed the market that average selling prices for new orders fell 9% over the last quarter, and they project further declines into the year’s end. Downside pressure in the housing market is essential to mention as more Americans have equity in their homes than they do equity in the stock market. Lower home prices could cause households to pull back spending as they feel less wealthy.
Demand destruction, courtesy of the Federal Reserve, will eventually balance out supply imbalances and bring inflation down. But, as we have warned in the past, the Fed’s battle with inflation could take longer than projected as the lagging effects of rental-related contributions to the inflation indices have a long tail. Moreover, as seen in the comments from one of the largest homebuilders in America, those positive contributions to inflation will reverse. When housing stops becoming a positive contributor to the inflation indices, we should expect to see interest rates decrease. We fear we could be in the early stages of an economic recession when these interest rate decreases come. As we discussed in a video call with our partners earlier in the month, we see numerous opportunities in the fixed income market representing good value for the first time in years. A risk/reward that looks strong compared to equities.
Overall, we remain concerned about the stock market and stay defensive in positioning. While investor sentiment is very negative, expensive earnings-based market valuations continue. Making valuations even more perilous is that analysts are still projecting 2023 earnings growth in the face of an impending global recession. In addition, parody “assets” like Dogecoin, created to poke fun at cryptocurrencies like Bitcoin, continue to trade with a market capitalization of more than $20 billion. While having no equity exposure is not realistic, we can position ourselves to limit exposure to material downside pressures (15-20% corrections). We are pleased with our continued and material outperformance compared to the popular equity and debt indices but recognize that we are not yet out of the woods. Global excess liquidity continues to be a significant negative headwind for financial asset prices as Central Banks tighten monetary policy worldwide. As a result, we project more downside in financial asset prices over the next three to six months.
Financial asset prices continue to correct near historic levels where the breadth of selling pressure is wide-reaching. Unfortunately, we project that this selling pressure will not abate in the near term as rises in interest rates have yet to be fully digested by the stock market. These near-term dynamics do not even consider the imminent risks to our economy. The chances of a 2023 economic recession are significant. With forward-looking earnings projections still estimating 8% growth rates, we are concerned that market participants will need to prepare for what could be an earnings contraction. Negative earnings growth could be the primary catalyst for the next leg lower in the stock market.
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