By Matthew McKee, CFA, CFP®
September 3, 2023
The first three weeks of the month were mired by Fitch’s downgrade of US Treasuries, Moody’s downgrade of several banks, slowing growth in China and declining industrial output in Japan. But what remains front and center is US Fed policy in response to continued inflationary pressures.
Inflation and employment data released during the month pushed the S&P 500 close to a 5% drop.
It may seem like volatility has returned to the market. But these 5% retreats are quite common, happening on average about 5 times per year going back to 1980.
The fact that markets have been relatively sanguine this year makes this pullback stand out more. The VIX, a measure of market volatility or “fear gauge”, sits around 13, below its 10-year average of just over 18.
We have been hit with one obstacle after another – the pandemic, inflation, trade war, actual war, supply chain issues, debt ceilings showdown, the collapse of several banks. The markets’ relative calm may seem surprising.
But the truth is that there are always concerns on the horizon. It’s these risks that we are rewarded for as investors. The perennial challenge for investors is to stay focused on fundamentals and our long-term strategies.
Our role as wealth advisors is to manage our clients’ assets in a way that reflects their goals, aspirations, and values, in the context of what’s occurring in current market dynamics.
The Employment-Inflation dynamic remains center stage
Even after the pullback in August, most broad market indices are up significantly for the year.
This is despite four further rate hikes in 2023, and a 525bp increase in interest rates since early 2022. It is also on top of the fact company earnings have declined.
Markets have rallied primarily on price-to-earnings multiple expansions, a result of investors’ continued hopes of abating inflation and easing Fed policy, despite scant indication that this is on the horizon. Based on current 2023 and 2024 consensus estimates, the S&P 500 is trading at 20- and 18-times earnings, respectively. These valuations would be fairly rich even in a lower interest rate environment.
So, when the July core CPI came in slightly higher than expected at 4.7% on August 10, the probability of another 25bp rate hike in the November Fed meeting increased from 28% to 34% in a single dayand markets retreated.
Then, on August 24th, strong employment data with lower-than-expected jobless claims added to the case for further rate hikes, and the probability of a November rate hike ticked up again. It now sits at 42%.
Then the good news (or bad, depending on how you look at it) came this week with a trifecta of negative economic indicators. A lower-than-expected consumer confidence report, a decline in job openings, and a higher unemployment reading on Friday. Labor force participation hasn’t changed much as household balance sheets remain healthy and people aren’t being forced back into job hunts, at least not yet. Declines in job openings are certainly a softer stick than layoffs.
Core PCE, the Fed’s preferred inflation measure was released on the final day of the month at 4.7%, in line with expectations but still above the Fed’s 2% target.
Falling between these economic reports was Fed Chairman Powell’s speech from Jackson Hole on the 25th, where he struck a decidedly hawkish tone. Here are his opening comments:
“It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so. We have tightened policy significantly over the past year. Although inflation has moved down from its peak—a welcome development—it remains too high. We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”
The Fed was criticized for moving too late on inflation coming out of the pandemic. They have been clear that they won’t ease monetary policy until inflation has clearly improved for some time. So, even if inflation moderates further, that still won’t mean cuts are imminent.
Besides a few bank failures, there hasn’t been much financial collateral damage from this rapid succession of rate hikes. That’s the glass-half-full view. The glass-half-empty says we still haven’t felt the ramifications of this monetary policy and the other shoe can still drop.
Our portfolio positioning
At the end of the day (or month), our strategy has not changed. We don’t see rate cuts as the baseline scenario in the near term and remain modestly tilted toward higher-quality companies with stable earnings and low financial leverage. These should hold up well in a higher-for-longer rate environment (or worse, a true growth scare and market pullback) and portfolios overall are well-positioned to benefit from increasing market breadth when the focus returns to earnings and not just interest rates.
We will have a more comprehensive update to our outlook and positioning in next month’s quarterly update. In the meantime, if you have any questions or would like to discuss your portfolio positioning, please feel free to reach out.