“The ability to buy securities – particularly common stocks – successfully is the ability to look ahead accurately... It requires a skillful mental balance between facts of the past and the possibilities of the future.”
Benjamin Graham, 1894 – 1976, Economist and investor; known as ‘The Father of Value Investing’
WHEN GOOD NEWS IS BAD NEWS FOR THE MARKETS
For the first time in many years, two movies based on original story lines generated genuine excitement at the box office this summer. The simultaneous release of two very different movies – Greta Gerwig’s bright satire of the Mattel doll “Barbie” and Christopher Nolan’s three-hour opus “Oppenheimer”, a film about the ‘father of the atomic bomb’ – was the biggest cinematic event since the pandemic shut the big screens. Collectively, they combined for the fourth-biggest box office weekend in history, and Barbie now holds the record for having the biggest opening for a film directed by a woman.
Sure, one is based on a toy and the other is a haunting biopic, but the double theatrical matchup dubbed “Barbenheimer” generated a great deal of hype and turned into a real-world phenomenon, inspiring pink themed parties and pool floaties, countless memes, and products ranging from mock-up movie posters to T-shirts featuring the slogan, “I survived Barbenheimer 2023.” Movie theaters joined in the excitement, offering pink beer and setting up Barbie-themed photo ops in the lobby. More than 200,000 people purchased tickets to see them back-to-back on the same day, according to the National Association of Theatre Owners.
The pair supercharged box office numbers even as two Hollywood union strikes have essentially halted movie production. The unprecedented revenues tied to these blockbusters had a notable impact on consumer spending and the broader economy. Media analysts at Morgan Stanley estimate that the twin summer box office phenomenon has brought in a combined total of about $2.3 billion in ticket and food sales, with international ticket sales potentially adding another billion.
Bank of America reported that its card holders spent 13.2% more on entertainment during the opening week (ending July 22) than they had a year ago, “likely partially driven by the release of the much-anticipated movies.” At the same time, the Commerce Department confirmed the box office draw of the two films: outlays at movie theaters soared at an annualized rate of 10.7% in July. The report also showed that consumer spending, the economy’s main engine, increased a healthy 0.8% that month, suggesting that the July - September quarter is shaping up to be a strong one for the U.S. economy.
When asked about how skyrocketing demand for certain movies and concerts (think Taylor Swift and Beyoncé) is impacting the broader economy, Federal Reserve Chair Jerome Powell said that the “overall resilience” of the economy, coupled with cooling inflation and rebounding consumer confidence, is largely a “good thing.”
In the face of the Fed’s efforts to slow economic growth, the labor market’s surprising strength, highlighted by consistently low unemployment and solid job growth, has helped avoid what many industry analysts anticipated: the high likelihood of a recession this year. As has been the case repeatedly over the past year, a steady stream of stronger-than-expected data on everything from consumer spending to residential investments has continued to humble forecasters and confound economists.
After 11 interest rate hikes over the past 18 months, the most aggressive inflation-busting campaign since the early 1980s, the Fed opted to hold interest rates steady in September, leaving the federal funds rate at a 22-year high of 5.25 to 5.50%. However, policymakers raised their quarterly Summary of Economic Projections (SEP) – a consensus of Fed officials’ assumptions for monetary policy and economic conditions – in which they now predict stronger economic growth and employment, with a continued gradual decline in inflation. Median projections for GDP growth this year more than doubled from 1.0% to 2.1% in June – the last time policymakers updated their own numbers –, while 2024 estimates were raised to 1.5% from 1.1%, signaling that they are more optimistic about the prospects for a ‘soft landing’ for the U.S. economy.
Stronger than expected economic growth bodes well for the Fed’s efforts to cool inflation without sending the economy into a recession (‘soft landing’), but it also raised concerns at the central bank that the inflation fight might be prolonged. The Fed’s ‘dot plot’ depiction of individual members’ interest rate expectations suggests 12 of the 19 FOMC members anticipate one additional rate increase by the end of 2023 (see graph on this page). But the bigger takeaway for investors was the revelation that policymakers see fewer rate cuts than previously anticipated in 2024, in part due to a stronger labor market. They now predict that their benchmark rate will still be 5.1% by the end of next year, up from 4.6% in the last projection in June to contain the worst outbreak of inflation in 40 years. Thus, the conversation has decidedly shifted from ‘how high’ the Fed should hike rates to ‘how long’ they should stay elevated. Ultimately, the degree to which the job market and economic growth weaken will play a big part in determining how long central banks will wait before they start cutting rates again. As consumers confront a range of challenges including the depletion of pandemic savings and the resumption of student-loan repayments, that spending momentum could wane rather quickly.
While inflation levels have been trending lower in 2023, both the Consumer and Producer Price Indexes (CPI and PPI respectively) were stronger than expected in August. Likewise, core consumer and producer prices, which exclude the more volatile food and energy components moved in the wrong direction for a Fed that is data-driven in formulating monetary policy (see the graph above).
The central bank’s preferred inflation measure, the Personal Consumption Expenditures (PCE) index excluding the cost of food and energy, or so-called ‘core PCE’, showed prices rose 4.2% year-over-year in July, up from the 4.1% recorded in June and still more than double the Fed’s target of 2%. Headline PCE, which slowed to 3% in June also bounced higher to 3.3%. The uptick in both indexes suggests that inflation is still very sticky as increases in services costs offset a decline in the price of goods.
Even though signs point to a continued slowdown in inflation over time, a sharp increase in energy prices, rising insurance costs, especially for motor vehicles and healthcare services, along with tenacious housing and shelter costs (rent comprises 40% of the core CPI price index) are tilting inflation risks to the upside in the near term.
Record levels of oil demand, fueled by unexpected economic strength, and cutbacks in supply by oil-producing countries in the OPEC+ cartel, including Saudi Arabia, have outstripped production and drained oil stockpiles at a rapid clip. Oil prices have surged by over 30% since June, with the benchmark U.S. crude briefly topping $95 a barrel (see the chart below). The big jump in gas prices accounted for more than half of the increase in the August CPI, pushing inflation in the wrong direction. This comes at a time when a fledgling auto worker strike threatens to put pressure on already-high car prices, and demands for hefty pay raises could end up rekindling inflation. The Fed’s battle against inflation has reached a tricky phase, and these developments are unwelcome to say the least.
The potential for an additional rate hike, and the expectation that the Fed would leave rates elevated for longer to tamp inflation caused long-term U.S. Treasury bond yields – which serve as a benchmark for many home mortgages and other key consumer and business borrowing rates – to climb to multiyear highs. Benchmark 10-year Treasury yields rose to 4.64%, a peak not seen since 2007, while the 30-year bond reached 4.74%, its highest level since 2011 as investors reassessed the likelihood of higher-for-longer rates.
But the Fed isn’t the only reason that bond yields are moving. Other factors contributing to the push higher in bond yields are Quantitative tightening (QT) – the central bank’s effort to unwind its balance sheet by selling bonds – as well as the U.S. Treasury’s heavy pace of new debt issuance. The U.S. government raised an ‘eye-popping’ $1 trillion through bond sales in the third quarter alone, throwing off the supply/demand dynamic of the bond market.
Even as the U.S. economy expands, the federal government continues to run large and growing budget deficits that are expected to balloon to about $2 trillion for fiscal year 2023, roughly double what it was in the previous fiscal year and a rate of growth unequaled except during recessions or the Vietnam War. That prospect is making investors uneasy and they are asking for higher yields for the risk of holding longer-dated bonds.
Meanwhile, the national debt has officially eclipsed a staggering $33 trillion, providing a stark reminder of the country’s shaky fiscal trajectory at a moment when Washington faced the prospect of another government shutdown. Concern over “the expected fiscal deterioration, a high and growing general government debt burden, and a steady deterioration in standards of governance” led Fitch Ratings to downgrade the U.S. government’s top AAA credit rating by a notch to AA+ in August. It was only the second time in the nation’s history that its credit rating has been cut. In 2011, S&P stripped the U.S. of its prized AAA rating after a prolonged fight over the government’s borrowing limit.
While Congress narrowly averted a government shutdown for now by passing a last minute 45-day stopgap bill that provides temporary funding, the country’s credit rating could face additional pressure if an agreement to avert another potential shutdown cannot be reached by November 17. A government shutdown would be a ‘credit negative’ for the U.S. sovereign, and “would demonstrate the significant constraints that intensifying political polarization put on fiscal policymaking at a time of declining fiscal strength, driven by widening fiscal deficits and deteriorating debt affordability,” Moody’s Investors Service cautioned.
Eventually, the U.S. government will face a crisis if it does not find ways to reduce the deficit and subsequent borrowing. The crisis may be many years away, but it should surprise no one when it finally does hit.
Investors’ perception that the central bank would maintain elevated interest rates for an extended period attracted a flood of money into money market funds as interest rates north of 5% lured cash from banks and other short-term investments. Money market funds, which typically hold very low risk assets such as short-dated debt are on track to take in a record $1.5 trillion this year, according to Bank of America.
The dollar index, a measure of the greenback against six peer currencies rose to its highest level since November last year, driven by what’s seen to be superior U.S. growth, especially relative to peers in the European Union, Japan and China.
Moviegoers might have donned rose-colored glasses, but the mood on Wall Street was not nearly as rosy. After a trying 2022 when seemingly nothing went right for investors, stocks and bonds staged rebounds in the first half of 2023, despite a series of challenges ranging from falling corporate profits, to some of the largest bank failures in U.S. history, to consensus predictions of an imminent recession. Then both, stocks and bonds hit a rough patch in August and September as the harsh reality of ‘higher-for-longer’ interest rates caused yields on longer-term government bonds to soar and the stock market’s fierce rally to stall. High and rising interest rates tend to weigh on stock valuations as they can affect future corporate profits and growth potential and reduce the worth of that anticipated growth. Higher yields also tend to make income producing investments, such as bonds, more attractive relative to riskier assets like stocks.
During its seven-month rally from January through July, the S&P 500 gained nearly 20%, with the bulk of the market’s favorable returns being propelled by a narrow group of richly valued stocks, most associated with technology-oriented companies. But the third quarter ended on a down note with the S&P 500 declining 1.4% in August and dropping another 4.9% in September, leaving the benchmark index to cling to a still respectful 12% advance for the year. So, despite T.S. Eliot’s poetic vote for April as the ‘cruellest’ month, for investors, that unwanted label got once again attached to September (see graph below). That said, an overwhelming proportion of the S&P 500’s return has been driven by its seven largest stocks – dubbed ‘The Magnificent Seven’ –, which heavily influenced the market-cap weighted index and contributed almost 65% of the year-to-date (YTD) returns, camouflaging fairly paltry returns from the rest of the index.
The yield on the benchmark 10-year U.S. Treasury note closed out the quarter at 4.57%, up from 4.09% at the end of August.
Monetary policy works in long and variable lags, and it’s therefore unclear how much the Fed’s previous rate hikes have affected economic activity and financial markets, and how much of that impact is yet to come. Complicating its strategy are several uncertainties that Fed Chair Powell referred to as “navigating by the stars under cloudy skies,” with policymakers attempting to balance the risk of doing too much – and potentially trigger a sharp rise in unemployment and a subsequent downturn – against the risk of too little, which could allow inflation to become entrenched. Given the economy’s continuous outperformance, policymakers are not anywhere close to declaring ‘Mission Accomplished.’
Investors are confronted with a complicated picture as well, as they try to anticipate the market’s next moves. Will interest rates stay elevated? Can the economy avoid falling into recession? As has been the case for the past few years, the Fed’s actions – or lack thereof – will heavily influence investor behavior and market performance. At the end of July, when the S&P 500 closed at its 2023 high, traders assigned an 87% chance that the central bank would lower its benchmark rate by its June 2024 meeting, according to the CME Group’s FedWatch tool. That view has now changed after policymakers last month projected that rates will remain elevated until the end of 2024. The market’s extended selloff in September may indicate that the Fed’s message is now loud and clear.
Uncertainty around the economy and markets remain high, and we believe it’s fair to anticipate that equity markets may continue to exhibit price volatility in the near term and we believe that investors should exercise some caution in this environment. While bouts of market volatility can be unnerving, they are a normal feature of long-term investing. Against this backdrop, we believe it’s prudent for investors to maintain a proper perspective about the markets and properly diversify risk exposures. Pullbacks can by used as opportunities to buy high-quality companies with strong fundamentals and durable business models at attractive valuations. In the end, your portfolio needs to help you accomplish your long-term goals – and that has nothing to do with the daily ups and downs in the market, but with having an objective and disciplined approach to investing that removes emotion and bias, and the discipline to stay the course with your plan even if it doesn’t feel like the right thing to do.
Ultimately, asset prices tend to perform well when the central bank is finally done raising interest rates. An analysis of the end of the last four Fed hiking cycles found that both, equity and fixed income returns were strong in the year that followed, according to research from Capital Group. Importantly, for long-term investors, these asset classes maintained relative strength over a five-year period. That will be the time for investors to don rose-colored glasses!
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