September Investment Perspectives

Near-Term Uncertainty is High

Mark Luschini, Chief Investment Strategist

Against a particularly uncertain macroeconomic backdrop, we have reduced conviction in our near-term views.

Inflation and its impact on consumer spending are the primary concerns clouding our perspective about the economy and stock market. The path of inflation and its impulse on consumption will perform an integral role in gauging the risk of recession or its severity.

Current Financial Readings

We acknowledge the risk of recession (setting aside the somewhat crude definition of two consecutive quarters of negative GDP, which the U.S. has now incurred) is quite elevated. It seems that only a swift and substantial decline in inflation, thereby allowing the Federal Reserve to moderate its monetary tightening and push real incomes positive, can alleviate that risk, or at least postpone it. While several recent readings on inflation are encouraging, they are still a long way from the Federal Reserve’s target of 2%. Monetary officials have been clear that they do not perceive a reason to slow or stop tightening rates anytime soon.

The good news is some recent economic data have been better than expected. While not necessarily robust, data have been strong enough for the Federal Reserve Bank of Atlanta, via its real-time tracker of GDP, to post a positive, albeit below trend, pace of growth so far in the third quarter. However, several developments over the past month continue to highlight the elevated risk of a recession in the near future.

The Conference Board’s Leading Economic Index (LEI) includes 10 components that have historically been predictive in foreshadowing future activity. One of the primary indicators released from the LEI dropped for a fifth consecutive month in July, which typically only precedes recessions. This, in turn, has supported our belief that investors should stay neutrally positioned toward equities in a balanced portfolio.

The Global Picture

While the United States is a fairly closed economy, where exports are just over 10% of GDP, it is not immune to activity in the rest of the world. In Europe, signs point to a recession ensuing in the very near future as a consequence of high inflation that is exasperated by the energy price spike emanating from both the oil and natural gas markets.

China, the world’s second largest economy, has been taking myriad steps to stabilize, if not reflate, the country’s growth but they have been only marginally stimulative so far.

Collectively, the almost ubiquitous effort by central banks around the world to hike rates to thwart inflation have cooled global activity, with no signs of reacceleration immediately apparent.

Heightened Volatility

The equity market rally that began in June was based on the assumption that disinflationary forces are emerging that could allow the Federal Reserve to become more lenient. However, this assumption was probably misguided.

We anticipate markets will be subject to further volatility as subsequent inflation reports and the last three Federal Reserve Open Market Committee (FOMC) meetings of this year leave plenty of opportunity for two-way surprises. FOMC meetings are the formal settings policymakers use to make decisions about potential changes in monetary policy.

For now, a judicious approach to allocating risk-based capital is warranted until further clarity develops on the inflationary, consumer, and economic fronts. We will likely turn more constructive if inflation abates, the labor market remains strong, and estimates for year-over-year corporate profit growth stay intact. Stay tuned

Does Quantitative Tightening Matter?

Guy LeBas, Chief Fixed Income Strategist

Federal Reserve monetary policy matters a lot for markets.

For fixed income, policy is arguably the single-biggest input into returns (although economic conditions inform policy). Certainly, in the post-Global Financial Crisis world, many investors believe, rightly or wrongly, that Fed policy is the largest input into equity returns as well. In 2020-2021, policy was easy or easing, as evidenced by zero overnight interest rates plus tens of billions in monthly Fed bond buying, the latter a policy known as quantitative easing (QE). Today, policy is tightening, as measured by repeated rapid increases in overnight interest rates and the reverse of that bond buying, a policy which has earned the perhaps obvious designation of quantitative tightening (QT).

Fed Ramps Up QT

The Fed began preparing for QT in January 2022, but the program started in June. At the beginning of June, the Fed owned about $5.8 trillion of Treasury notes and bonds and about $2.7 trillion of mortgage-backed securities (MBS). Each month, some of these Treasuries mature and some of these MBS pay down. In order to minimize market plumbing disruptions, Fed policymakers chose not to sell bonds, but rather to let these maturities and paydowns occur on their own, subject to limits (namely $60 billion/ month of Treasuries and $35 billion/month of MBS). If there are maturities and paydowns greater than the caps, the Fed goes out and buys back bonds to replace the excess. Three months in, the QT process has gone smoothly—if more slowly than hoped—and is continuing at a run rate of about $73 billion per month.

Table 1: Pace of QT Should Stabilize Around $73 Billion/Month

In future months, the Fed could increase the caps, allowing QT to progress more rapidly. However, policymakers thus far have avoided publicly talking about that idea. One worry is that, by shrinking asset holdings, the Fed is also shrinking something called “reserves” in the banking system. If reserves get too thin, liquidity crises can result, such as the September 2019 spike in short-term interest rates.

To ensure the banking system has sufficient reserves, the Fed will probably end up slowing QT or perhaps stopping it entirely by mid-2024, leaving the Fed with $4.35 trillion in Treasury holdings and nearly $2.4 trillion in MBS holdings. Policymakers will then probably allow MBS to continue paying down but replace those paydowns one-for-one by purchasing short-term T-bills.

Table 2: Market Returns on QT Day Have Been Positive

What it Means for Financial Markets

All of the discussion up to this point has been about mechanics. More interesting, however, is the question of whether QT actually matters for financial markets. There’s no shortage of pundits who claim that, on specific days in which bonds mature from the Fed’s portfolio, liquidity gets “sucked out” of financial markets and both bond and stock valuations fall. Since these maturities occur on specific dates, we can look at those dates to identify whether that claim holds. Thus far, not so much. While there have only been seven instances of QT “days” so far, the bond markets have been up, on average, +0.3% on those days, and have been flat on average in the five days after a QT payment. The story is even better for stocks, which have been up an average of +0.5% on QT days. That’s not exactly consistent with the pundits’ fears.

A September to Remember or One to Forget?

Gregory M. Drahuschak, Market Strategist

By August 15, 2022, the S&P 500 had a 17.4% gain from its most recent low on June 16, 2022, which suggested that last month might be one of the better Augusts in many years. Instead, technical resistance at its 200-moving average and the August 26, 2022, speech by Federal Reserve Chairman Jerome Powell sent the S&P 500 into a downward spiral that ended with the index down 4.24% for the month.

The Fight Against Inflation

In one week, Powell’s speech at the Jackson Hole Symposium erased 300 points from the S&P 500 and made it clear that the fight to contain inflation was first and foremost on the Fed’s agenda.

For some investors, mentioning ex-Fed chairman Paul Volcker twice in his speech might have been the most worrisome part of Powell’s time at the symposium.

After serving as Fed chairman from 1979 until 1987, Volcker died in December 2019. An article written on his death detailed highlights of Volcker as Fed chairman and posed an interesting question about what America would do when high inflation returns after a long time away. Who will be the new Volcker?

Some people suggest we got the answer when Powell made it clear that interest rates would go higher. His Jackson Hole speech this August eerily came in the same month when 43 years earlier Volcker began a rate-boosting campaign from August 1979 through April 1980 that raised interest rates 59% above where they were previously in an effort to break the inflation rate that got as high as 14.5%. The fear that Powell might employ a credit policy approach similar to the one Volcker used sent a chill through the equity market.

Volcker’s reign of credit policy terror came after a decade-long series of economic policy mistakes and two oil embargoes that led to rampant inflation. Somewhat similarly, the currently elevated inflation rate at least partly is due to governmental policy errors compounded by the rapid rise in energy costs. Unlike Volcker’s time, however, the awareness of the need to quell the inflation push has become a primary concern much sooner.

Market Expectations

September has a bad reputation relative to market results, but it is not as bad as many investors think. Of the 22 Septembers since 2000, the S&P 500 has had negative results for the month 12 times for an average 1.08% loss.

These results, however, were significantly impacted by the recession-induced loss in 2000-2003 and the Great Recession in 2008. Taking out these periods, the average result improves to a positive 0.65%.

Chart 1: S&P 500 September Results 2000 to 2021

This year is following a well-documented midterm election pattern of stock market weakness in the early part of the year. This usually is followed by a strong fourth quarter and solid market results the next year, as the S&P 500 has had gains in 17 of the 19 years after the midterms for an average of 16.36%. In 14 of these years, gains were in double-digit percentages

Table 3: Midterm Election Quarterly % Results for the S&P 500

Although the stock market faces some key headwinds like higher interest rates and what might be a stubbornly high inflation rate, corporate earnings expectations have held up well so far. If this continues, the final quarter of 2022 could continue the midterm election pattern. If, however, earnings expectations slip, the market will lose its most important support.

The reporting period for third-quarter earnings will not begin until mid-October, but if earnings deterioration appears likely, companies will begin offering earnings warnings well ahead of the formal reporting period.

Summary

Entering what often is a volatile market period, technically inspired trading could be a dominant factor this month.

The rally off the June 16, 2022, low surpassed several levels of modest resistance before eventually running into more formidable resistance at its 200-day moving average. The S&P 500 then fell below its 50-day moving average.

Not regaining the 50-day average (4,013.50) could prompt a move lower that challenges the lower end of range since June.

Chart 2: S&P 500 Large Cap Index

Closely monitoring the market for an attractive level for new buying might be the most appropriate approach to the market this month.

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