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M o n hly M a r k e t C o m m e n t a r y
October 2023
In October, the investment landscape witnessed several significant shifts:
- In October, the S&P 500 initially showed promise with gains in the first half, but a sharp decline in the latter half led to a 2.34% monthly loss.
- Other major equity indexes fared worse, with the NASDAQ down 2.7%, the EAFE index down 4.03%, and the small-cap Russell 2000 down 6.8%.
- This marked the third consecutive monthly decline for the S&P 500, pushing it into correction territory, defined as a 10% drop from its previous high.
- Elevated yields continued to impact the market in October. The 10-year Treasury rate increased from 4.62% on September 30, 2023, to 4.92% at the month's end, reaching as high as 4.99% on October 19, 2023—a 16-year high.
- While October's inflation reports displayed positive trends, the pace of decline in inflation rates slowed.
- Federal Reserve officials had been signaling their intention to maintain the Fed Funds rate during the November 1st FOMC meeting, which they indeed did. Futures contracts indicated an 18% probability of a rate hike at the December meeting at the end of October, which has since decreased to just 6%.
- We perceive the current phase of "backing and filling" as an opportunity to lengthen investment horizons and diversify equity holdings beyond large-cap technology.
- Despite October's challenges, historical data indicates that equity markets typically perform better in the fourth quarter, rebounding following third-quarter declines after a strong first half of the year. This leads us to remain cautiously optimistic about the potential for a strong year-end.
There were multiple reasons for the risk-off sentiment in October, which led to the “corrections” in the broad equity markets. In the first week of October, the US equity markets started out strong, seemingly rebounding from the weakness in August through September. It was reminiscent of March of this year when large-cap growth and tech stocks, or Magnificent Seven stocks, were doing very well, and other parts of the market were down. The NASDAQ was up over 1%, while the smaller cap Russell 2000 was down.
In the second week of the month, Treasury yields started to move up dramatically, and equity returns fell off broadly. The 10-year Treasury declined to 4.55% in early October before reaching almost 5% by October 19th. The S&P 500 was up 1% in the first two weeks of October before declining more than 3% in the second half of the month. During the same week, Israel was attacked by Hamas, resulting in over 1400 casualties and over 200 hostages taken, the deadliest instruction into Israel since the Yom Kipper War 50 years ago. Israel has mobilized a record 300K reservists and started the ground invasion of Gaza.
October 17th was a particularly bad day for the market following a blast at a hospital in Gaza, which increased geopolitical tensions in the Middle East. President Joe Biden, when visiting Israel on the 18th, was turned down by meetings with Arab leaders after the hospital explosion. It was later reported that the explosion was from a misfired Hamas missel.
On October 19th, Fed Chairman Powell gave a market-moving presentation. Powell said more tightening could be needed if the “recent run of strong economic data continues,” but he also said that "financial conditions have (already) tightened significantly" with the increase in bond yields recently. Powell said the Fed would "proceeding carefully," indicating no rush to hike again. In the discussion that followed his remarks, Powell talked about the unexpected degree of economic strength. "It may just be that rates haven't been high enough for long enough." Earlier in October, the September employment report and the retail sales number continued to show US economic strength.
Source Bloomberg, Mill Creek
The surprising strength of the US economy led to an increase in bond yields, creating a "Good News is Bad News" environment. In the third quarter, the GDP exceeded expectations with a robust 4.9% growth, surpassing the predicted 4.2% and more than doubling the previous quarter's rate. Durable goods orders for September also outperformed expectations, rising by 4.7% compared to estimates of only 1%. Similarly, September's pending home sales displayed strength, increasing by 1.1% against expectations of a -1% decline, marking an improvement from the 7.1% decrease in August.
The October surge in Treasury yields can be attributed not only to the strong economic performance but also to increased government issuance. This year, the total amount of treasuries issued is projected to reach over $3 trillion, surpassing levels seen in the past decade, including during the pandemic. Towards the end of October, however, the US Treasury's quarterly borrowing estimates came in slightly lower than anticipated at $776 billion, which is $76 billion less than the June estimate of $852 billion. This indicates that projected receipts are offsetting higher outlays, reducing concerns about large deficits in 2024, despite the potential for a broader economic slowdown. Treasury yields have been on a declining trend since reaching 16-year highs.
The Federal Reserve's stance on interest rates, whether officially concluded or not, has resulted in interest rates reaching levels not seen since the financial crisis. In this context, the widely recognized investment strategy of "TINA" (There is no alternative) has been rendered less applicable, and fixed-income investments now offer compelling real returns, especially in an environment characterized by declining inflation.
Despite recent above-average economic growth, inflation is moving in the right direction—downwards. The Fed's preferred measure of inflation, the Personal Consumption Expenditure (PCE), decreased to 3.7% in September, a decline from the previous month. Although it remains above the Fed's 2% target, it marks a significant drop compared to the previous year. Recent signs of weakening in labor markets and consumer spending suggest further improvements in inflation numbers. While inflation is receding gradually, it continues to move in the right direction.
On November 1st, the Federal Open Market Committee (FOMC) maintained the Federal Funds rate at the same level, with comments from Chairman Powell focused on the progress made in reducing inflation. This was seen as a dovish indication that the committee's rate hikes are coming to an end. According to current futures markets, there is only a 6% chance that the Fed will increase rates at the December FOMC meeting and a 10% chance at the January meeting. It is increasingly likely that the rate hike during the July FOMC meeting might have marked the conclusion of this tightening cycle. Historically, a Fed pause has been positive for the markets, with stocks typically showing gains between the last rate hike and the first cut. In rare instances of decline, the declines have been modest. Bonds have also delivered above-average returns when the Fed ceased raising rates.
The narrative on earnings has also improved, despite some companies facing negative reactions to conservative earnings guidance during the third quarter earnings season. With over 80% of the S&P 500 reporting earnings, 82% have exceeded expectations, with 62% beating revenue forecasts. The blended earnings growth for the third quarter is 3.7%, marking the first growth in earnings in three quarters. Companies that missed estimates have faced more significant negative reactions than seen in recent years. Analysts are also reducing estimates for fourth-quarter earnings to a greater extent than usual. Nevertheless, the current expectation of 12% EPS growth next year may be moderated, but it still represents an improvement from the earnings declines witnessed earlier in 2023.
Market corrections, while not enjoyable, are a common occurrence. According to Edward Jones, the average market correction since 1971 has lasted for four months and resulted in an average decline of 14%. Looking at historical data, the S&P 500 has typically rebounded, with an average gain of over 17% six months following market corrections since 1971 and a gain of 23% within 12 months.
Moreover, there are seasonal reasons for optimism during the remaining part of the year. Historical data indicates that the average return for November and December has been positive 70% of the time since 1945, with a mean gain of 3%, according to Morningstar.
A mild economic slowdown is likely on the horizon as consumer activity weakens, excess savings are depleted, bank lending becomes more stringent, and the US job market gradually cools off. This should contribute to inflation continuing its path in the right direction. Therefore, the near-term market volatility and "backing and filling" present opportunities to diversify equity holdings beyond the concentrated S&P 500 and extend bond durations. We believe that the recent market weakness will offer compelling investment opportunities, as the broader upward trend in equities follows the recent volatility.
