After a strong rally to start the month of October, the S&P 500 has reversed course as tensions in the Middle East continue to build. In addition to the increased geopolitical uncertainty, macroeconomic factors continue to dominate the headlines, swinging back and forth between positive and negative news flows. Interest rates have continued to march higher, especially for longer dated maturities while the labor market has remained surprisingly resilient. The end of October marks the transition from a historically weak period for stocks into a historically strong period. Finally, by the end of this week roughly 55% of companies in the S&P 500 will have reported earnings, with an additional 23% reporting the week ending Nov 3rd.
While the geopolitical tensions in the Middle East have grabbed the headlines over the short term, the rise in yields continues to be the main market theme over the medium term. Over the past 3 months, 10-year yields are up roughly 1%, a very large move for one of the most liquid markets in the world. This rise in longer dated yields has begun to unwind the yield curve inversion that first started 15 months ago.
The chart above illustrates the recent history of the Treasury yield curve through two lenses: the difference between the 3-month yield and 10-year yield in dark blue and the difference between the 2-year yield and 10-year yield in grey on the left, then light blue as we move right on the chart. For purposes of this discussion, we will focus on the 2-10 yield spread, though both paint a similar picture. As the Fed began to raise rates to fight inflation, shorter rates moved up faster than longer rates, creating the inversion (shorter rates > longer rates) in the yield curve. Now, as longer rates are rising faster than shorter rates, the inversion is becoming smaller and smaller.
Yield Curve Steepening
The main concern for investors right now remains the threat of recession. There is an almost universal belief that rates moving this high, this quickly will eventually have a slowing effect on economic growth. Many believe that yield curve inversions signal recessions. While inversions have been very good predictors of recessions in the past, the actual dis-inversion(rapid steepening) of the yield curve has been a more accurate signal on when things could get bad for markets. Going back to the chart from earlier we can see that steepening is taking place currently.
So if the rapid steepening of the yield curve has signaled trouble for stocks and the economy in the past, it must be time to sell, right? Well, not so fast. The main difference between this steepening and those in past recessions is where the steepening is happening. Historically, the steepening takes place on the front end of the curve as the market expects the Fed to CUT rates in an attempt to combat a slowdown in economic activity. In the current scenario, the Fed has been quit clear in their intention to keep short rates “higher for longer”, so short end rates have remained fairly stable. The longer end yields are the ones that are moving higher at a rapid pace.
The steepening scenario playing out right now is known as a Bear Steepener, (where longer rates move up faster than shorter rates) and isn’t necessarily bad for stocks. According to Ned Davis Research, going back to 1975, the market only sees a bear steepener about 10% of the time, with an average S&P 500 return of 9.5%. Why the difference? Mainly because the long end of the curve trades off a combination of inflation and growth expectations. Currently, the bond market is pricing in economic growth levels that are non-recessionary, assuming inflation settles back down to the 2-3% range.
Higher rates will also have an effect on stock valuations as the risk-free rate(higher) becomes more competitive, but that doesn’t mean things must fall apart. According to Factset Earnings Insight, the current 12-month forward P/E ratio on the S&P 500 is 17.7, which is below the 5-year average of 18.7, but slightly above the 10-year average of 17.5. The takeaway is that while pockets of stocks may be overvalued, the market’s valuation as a whole seems to be line with historical averages assuming those earnings estimates turn into reality.
Macroeconomic readings continue to be a tug-of-war. Leading Economic Indicators as measured by the Conference Board have fallen consecutively now for the past 17 months, though the rate of change continues to improve. The labor market remains resilient, but many are expecting the unemployment rate to increase in early 2024. The Atlanta Fed’s GDPNow tracker is forecasting Q3 real GDP growth of 5.4%. Bottom line, many have/are forecasting an imminent recession that continues to be evasive. That doesn’t mean things can’t change, but as of today, the data just isn’t confirming to “run for the hills!”
As of now, we are optimistic that a solid earnings season, positive seasonality and non-recessionary economic readings can combine with “peak hawkiness” from the Fed to set the table for a year end rally in stocks. In addition, bonds could see a short term rally as yields touch key resistance levels(5% on the 10-year Treasury) and positioning has become excessively bearish.
Weekly Focus – Think About It
“A creative person is motivated by the desire to achieve, not by the desire to beat others.”
• Ayn Rand
Performance last week for the four major asset classes were:
- U.S. Stocks – Russell 3000 (IWV) – Loss of –2.44%
- Developed Foreign Markets (EFA) – Loss of –2.72%
- Emerging Markets (EEM) – Loss of –2.83%
- Fixed Income (AGG) – Loss of –1.75%
(Note: performance is based on the change in price plus dividends)
Last Week’s Headlines
- 10-year yields continued their climb towards the 5% mark while 2-year bonds, which tend to follow closer to Fed policy rates, reached a cycle high of 5.15%
- Stock volatility increased as tensions in the Middle East create short term geopolitical uncertainty
Eye on the Week Ahead
- Core PCE, the Fed’s preferred measure of inflation, will provide clues to how effective Fed policy has been so far and if the Fed is inclined to raise rates another .25%
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