November 6, 2023

Last week’s bond and stock market rallies were fueled by a friendlier than expected Treasury quarterly refunding announcement, a rather benign FOMC meeting, and a softer than expected October jobs report that reinforced views that the Federal Reserve (“Fed”) is likely finished with its rate hiking campaign.  Fed Chairman Jay Powell confirmed that tightening financial conditions were reducing the need for further rate hikes, but reiterated that the Committee remains data dependent and tighter for longer remains the preferred prescription.  Last week’s plunge in bond yields and rising stock prices, however, raise fresh doubts about the necessary “persistence” of tightening financial conditions underlying the Fed’s position.

The economy appears to be slowing now after a red hot third quarter as the cumulative toll from the Federal Reserve’s tightening campaign begins to weigh on activity.  Consumption was very strong in September (and all of Q3), but rising consumer headwinds portend weaker spending ahead.  Additionally, the strong inventory accumulation that also contributed to third quarter GDP growth is unlikely to be sustained and is more likely to be a headwind this quarter as it reverses.

The “classic” ISM readings for both manufacturing and services weakened notably in October, contrary to the initial “Flash” PMI readings.  With the increase in the reported unemployment rate to 3.9% for November, we would expect to begin hearing more discussion of “The Sahm Rule”, which states that when the three-month moving average of the national unemployment rate rises by 0.50 percentage point or more off its low during the previous 12 months it has always signaled the start of recession.  We are now two-thirds of the way there.  A triggering of the “Sahm Rule” would join other historically-reliable indicators such as an inverted yield curve, declining Leading Economic Indicators, and tightening bank credit that are already signaling a looming recession.

Third quarter earnings are beating expectations, but earnings estimates for the fourth quarter and beyond are being revised lower to reflect a more challenging macroeconomic environment.  Calendar year 2024 earnings remain at risk in our view as economic growth and inflation slows, leading to disappointing revenue and margins.

We remain concerned by the level of investor complacency.  Despite additional geopolitical risks from the war in the Middle East, the CBOE Volatility Index (VIX) and WTI (measure of crude oil per barrel) are both lower than they were on October 6.  We remain mindful of near-term market headwinds: (1) stocks are fully valued; (2) too much investor complacency; (3) increasing consumer headwinds; (4) 2024 earnings estimates at risk; (5) rising geopolitical tensions; and (6) growing political uncertainty as we enter a new presidential election cycle.  Positive offsets to these headwinds, for now, include: (1) ongoing fiscal dominance (the effects of fiscal policy continue to outweigh monetary policy) and (2) favorable stock market seasonality (November through April historically has proven to be a friendlier time for equity investors).