What’s Going on in the Markets October 31, 2023

With so many global crosscurrents--another Middle East war, an uneven economy, stubborn inflation, and high interest rates, it’s no surprise that many will be happy to forget about October 2023. While nothing weighs as heavily as the horrific tragedies of the war in the Middle East, the stock markets saw their third consecutive down month after a terrific run up from the October 2022 bottom. Let’s look at what's weighing on the markets and what might be ahead.

Stubborn Inflation

Over the past year, I’ve expected inflation to retreat from its historically high level. But I've also stated in past writings that inflation pressures would be more stubborn than many on Wall Street believed.

After easing to 3.0%, the Consumer Price Index (CPI) has increased for three consecutive months and is now at 3.7%. Furthermore, measures of underlying inflation have started to reaccelerate.

In the latest Personal Income and Outlays reports, inflation showed an unwillingness to continue its recent descent. On Friday, October 27, the Personal Consumption Expenditures (PCE) for September showed inflation up 0.3% monthly (3.7% annualized). The PCE is the Federal Reserve’s (AKA The Fed) preferred measure of inflation.

While both inflation numbers are much improved over the 5%+ rates we saw earlier this year and last, they are a far cry from the Federal Reserve’s 2% annual inflation target.

Sticky Price CPI, which measures prices that are slower to change, like medical care, education, and housing, has resumed its increase. The annualized 3-month rate of change has shot up from 3.4% in July to over 4.4% last month. This is one of its highest readings of the past three decades outside of the post-pandemic surge. This suggests The Fed may have trouble getting inflation back to its 2% target.

Inflation measures are important not only because they erode the buying power of our dollars but also because they affect consumer sentiment, and sentiment influences consumer spending. Unhappy or non-confident consumers spend less, and less consumer spending can lead to an economic recession (which does not help keep stock prices up.)

High Interest Rates

To control inflation, The Fed adjusts short-term interest rates to cool consumer and business spending. The thinking is that higher interest rates discourage borrowing, which leads to lower demand, and lower demand presumably tends to portend lower prices.

The Federal Reserve meets about every six weeks to decide whether it will raise, lower, or hold short-term interest rates, considering various economic reports and factors. The last time they met was in September when they held short-term interest rates at 5.0%-5.25%.

In a meeting that concludes on Wednesday, November 1, they are widely expected to continue holding rates at this level. Many will listen to Federal Reserve Chairman Jerome Powell’s comments to assess the prospect of future higher or lower short-term interest rates. I think they’re done hiking rates but won’t hint at any rate reductions, which Wall Street is looking for.

The good news is that higher interest rates mean that cash is no longer “trash.” You can earn a 4.5%-5.5%+ return on your money market savings, CDs, and bonds. The bad news is that higher interest rates mean lower bond prices and may lead to an unprecedented 3^rd consecutive year of bond price declines (interest rates and bond prices are inversely correlated). In addition, higher interest rates on cash and bonds mean less of an urgency to take risks in the stock market, especially if one can get 5%-6% risk-free (no doubt that this sentiment has contributed to the pullback in the stock market over the last few months.)

Faltering Housing

Housing is one of the largest sources of wealth for consumers and a vital industry for the economy's health.

New Home Sales increased in September as homebuilders offered price-cut incentives and mortgage rate buydowns to attract buyers. Pending Home Sales, which tracks unclosed transactions of existing homes, ticked up in September but remained at the third lowest reading in its history.

Like consumer and business sentiment, homebuilder confidence is a crucial indicator to follow. It takes the pulse of current attitudes and can be an excellent predictor of future housing activity. Despite its rebound in the first half of the year, the National Association of Home Builders (NAHB) Housing Market Index (Builder Confidence Survey) is again falling. Today's low confidence levels indicate a much weaker outlook and reflect the effects of rapidly rising interest rates.

Today’s mortgage rates are at a 23-year high and heading toward 8.0%. This is a staggering increase of almost five percentage points since its record low in early 2021 and the second-quickest rise in history. The only faster increase in mortgage rates occurred in the early 1980s – a move only marginally steeper than today’s. Predictably, this has a significant impact on housing affordability.

Current multi-decade-high mortgage rates would be much more digestible to homebuyers if home prices weren’t still in a bubble. Unfortunately for them, prices have hardly budged. Home prices have surged by nearly 60% over the past five years, putting a significant strain on affordability. This problem has been exacerbated by rising mortgage rates, causing the average mortgage payment to increase by 134% since early 2018. And this doesn’t even include the increases in property taxes, insurance, repairs, maintenance, dues, etc. As a result, this is perhaps the most unaffordable time in U.S. history to buy a home.

Cooling Sentiment

Consumer and Business Sentiments are crucial to watch as their recent rebounds seem to be running out of steam. As mentioned above, consumer sentiment is essential to encourage spending and keep the economy “humming.” Small business sentiment is important because it encourages hiring, capital investments, and expansion. There are several surveys and measures of consumer and business sentiment, including widely followed surveys by the Conference Board and the University of Michigan.

October’s preliminary consumer sentiment readings plunged by more than forecast and were well below their 70-year average. Both Current Conditions and Future Expectations were down significantly. Inflation Expectations for the year ahead rose by 0.6 percentage points while expected business conditions for the next year dropped by 19%.

The latest and final October consumer sentiment readings from the University of Michigan finished October at 0.8 points higher than its preliminary reading yet is 4.1 points below September’s final reading. A significant reason for the decline in Consumer Sentiment this month was a rebound in consumers’ inflation expectations for the year ahead, which jumped from 3.2% to 4.2%.

The National Federation of Independent Businesses (NFIB) Small Business Optimism Index has been below its 49-year average for the last 21 months. Among small business owners, significant concerns remain regarding inflation, labor availability, and future economic conditions. As small businesses often need capital to grow, they are the most affected by high interest rates, and it is no surprise they are worried about the future.

I’m concerned about business and consumer sentiment because the readings I’m seeing have rarely occurred outside of an oncoming recession. Business owners are struggling, and there are signs that strong consumers are starting to tighten their belts.

Another Middle East War

As the horrific events in the Middle East continue to develop and command the attention of the world, economic issues may seem relatively unimportant. However, the Israel-Hamas conflict creates geopolitical risks with potential global economic consequences, and it may be helpful to consider early projections and analysis of how these consequences might unfold.

Any impact comes when the global economy is fragile, already strained by the ongoing Ukraine-Russia war, and facing challenges such as weak growth, economic fragmentation, high interest rates, and stubborn inflation.

On the other hand, the U.S. economy appears relatively strong by many measures, and the United States is the world's largest oil producer and thus relatively insulated from small shifts in the global oil supply that usually occur during wartime.

While U.S. military support of Israel will add to expenditures that have already been increased by the Ukraine war, U.S. Treasury Secretary Janet Yellen has indicated that the United States can support both allies. Of course, that will lead to even more inflation, causing spending deficits.

Many U.S. technology companies have production or research and development facilities in Israel. However, work in those facilities is expected to continue except for employees called for reserve duty.

So far, the U.S. stock market reaction to the war has been relatively muted. Historically, wars outside U.S. borders tend not to create lasting trouble for the domestic stock market.

Clearly, it is still early, and the economic situation can change anytime. For now, while the Israel-Hamas conflict is a tragic humanitarian crisis, it is not a reason to change your personal financial or investing strategy.

Wobbling Stock Markets

October has been living up to its reputation for being a volatile month in the stock markets and closing down for the third consecutive month (-2.2%). The S&P 500 index is down over 9% from the peak in July 2023. However, we are entering a seasonally favorable time of year in the markets. November to December tend to be stronger months of the year, but as a pre-election year, it has even more favorable seasonality. Finally, when the market is so strong as it was through July, historically, it has also portended a nice finish to the year.

But given the headwinds just discussed, any year-end rally could fail to meet expectations or, worse, not materialize.

There is a continuing debate about whether the October 2022 lows ended the bear (down trending) market that started in January 2022. Some assert that a new bull (up-trending) market was born and that we are in the early innings of an upward trend, the start of a new bull market. Others assert that the bear market is intact, and all that we’ve witnessed since October 2022 was an extended bear market rally, which is now over. Only in the fullness of time can we know which camp is right.

The bears will point out that it is unprecedented to have a 10% correction in the first year of a bull market. It’s also unusual to see small capitalization stocks struggle so much in the early stages of a new bull market. In fact, the small caps are down for the year and are at risk of undercutting their October 2022 lows. Thus, the outsized correction and narrowness of the rally from the October 2022 bottom gives me food for thought and leaves me a bit skeptical that we’re in a new bull market.

Currently, on the surface, the S&P 500 is up about 9.2% year to date. But if you take away the seven strongest tech stocks in the index, AKA the Magnificent Seven (Apple, Amazon, Meta, Microsoft, Microsoft, Nvidia, Tesla), the index would be only up slightly on the year. In fact, if you look at the equal-weighted S&P 500 index (where each stock gets an equal “vote” rather than being weighted by size), it is down 4.1% year-to-date. Clearly, most stocks are not participating in the “new bull market."

By all accounts, so far, third quarter 2023 corporate earnings are strong and beating expectations, though revenue growth is somewhat tepid. Much of the earnings growth comes from higher profit margins, meaning that cost savings are the primary driver of higher earnings, not strong and improving consumer demand.

Until seasonality asserts itself and strength re-emerges in the stock market, I believe caution and defensiveness are warranted for short-term investors. For long-term investors, this may be a time to pick some favorite positions you plan to keep for 3-5 years or longer. While this is not a recommendation to buy or sell any securities, this is when taking advantage of a stock market sale works in the long term. For our client portfolios, we remain hedged and recently slightly reduced our exposure to stocks, considering the risks discussed above.

Recession or No Recession?

When it comes to economic recessions, it’s a matter of when not if. So, while pundits continue to debate whether we’ll have a soft landing (no recession) or a hard landing (recession), they both might be right—just at different times.

The last recession we had in 2020, post-COVID, was short-lived thanks to the extraordinary fiscal and monetary stimulus unleashed on the economy back then. This, in my opinion, has contributed to the inflation hangover we’re now experiencing. Pass the aspirin, please!

In my opinion, despite a still strong job market and robust consumer spending to date, the weight of evidence points to several areas of gradual deterioration in the economy that will lead to a recession by mid-2024. Admittedly, I thought we’d be in a recession with much lower housing prices by now. But I obviously underestimated the strength and durability of the consumer with wallets full of cash and credit cards looking to spend after an awful and extended COVID lockdown. And I clearly did not anticipate how fast mortgage interest rates would rise, taking existing homeowners with low-interest-rate mortgages out of the housing market and making the supply of homes as tight as it is.

Today, we have a federal reserve intent on taming inflation, so interest rates will be higher for longer, which is not stock-market friendly. While many might not dump their existing stocks in this new high-interest rate environment, they might not be as willing to take on more risk in a world where 5%-6% returns come “risk-free.” And while a stock market buyer's strike might not be as bad as all-out selling, it certainly doesn't help stock prices rise to the level of a new bull market.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so are your financial plan and investment objectives.

Source: InvesTech Research