by Ellen Hazen, CFA®, Chief Market Strategist

September Takeaways:

• Core inflation continues to wane while headline inflation is reaccelerating. Core inflation (ex-food and ex-energy) has decelerated for the past five quarters, with the most recent August reading of 4.3% below July’s 4.7%. Headline inflation has reaccelerated due to higher food and energy prices, from 3.2% in July to 3.7% in August. September CPI will be reported on October 12.
• Jobs are stable. Although decelerating overall year-to-date, new jobs continued to grow at a healthy pace, with 157,000 new jobs created in July and 187,000 new jobs created in August. The most recent unemployment rate has increased to 3.8% (which is low by historical standards), and the labor force participation rate is nearing pre-pandemic levels, at 62.8%, compared to February 2020 at 63.3%.
• Interest rates: The Federal Reserve (Fed) kept the Federal Funds rate flat at its September meeting. It also released its quarterly forward-looking statement of economic projections, which changed to reflect the stronger-than-expected economic data reported over the past three months. Fed officials now predict 2024 GDP growth of 1.5%, up significantly from their June forecast of 1.1%. They reduced the 2023 unemployment expectation to 3.8%, and the 2024 unemployment expectation to 4.1%. Contemplating this stronger economy, officials now expect only two interest rate cuts in 2024, down from four cuts expected three months ago.
• Equities declined in September; year-to-date returns are still respectable. The large-capitalization S&P500 declined by 4.8% in September, bringing year-to-date returns to 13.1%. Small- and mid-sized stocks performed worse during the month, declining by 6% and 5.3% respectively. International equities performed relatively better, declining only 3.4% in September. Year-to-date, international equities returned 7.6%, notably less than the S&P500. Two high-profile IPOs, ARM and Instacart, struggled to maintain their IPO pricing, reflecting a weaker equity market.
• The so-called “Magnificent Seven” stocks modestly underperformed. Those seven stocks (Apple, Amazon, Microsoft, Meta, Alphabet, NVIDIA, and Tesla) declined by an average of 5.4% in the month, while the average of the other 493 stocks in the S&P500 declined by 5.0%.
• Bond yields rose again. The 10-year government bond yield increased by nearly 50 basis points (0.50%), while the 2-year government bond yield increased by nearly 20 basis points. If yields continue to increase, or even simply remain at current levels, the overall bond market could see negative full-year returns for the third year in a row. Higher yields are a consequence of inflation above the Fed’s 2% target, driving higher short-term rates and, indirectly, higher long-term rates. Credit spreads remained flat in the month, suggesting that bond investors are not anticipating a recession.
• Labor issues are still front and center. Any relaxation from the strike-averting July settlement with UPS was reignited in September, with the United Auto Workers (UAW) striking at multiple automotive plants. After several months, the Writers’ Guild strike was resolved in September, but the actors were left hanging.
• Government shutdown has been averted – for now. Congress passed a continuing resolution at the eleventh hour that extends funding for another 45 days until mid-November.
• Europe is slowing. Both European GDP and Purchasing Manager Indexes (PMI) came in worse than expected during September, highlighting that Europe may be sliding toward a recession.

What We Are Watching in October

• Earnings: Companies will start reporting Q3 2023 earnings in mid-October. Currently, consensus estimates are for a 1% decline on a year-over-year basis, compared to a 5.5% year-over-year decline reported for Q2 2023.
• Preliminary GDP for Q3 2023 will be released on October 26. The Atlanta real-time GDPNow forecast is currently predicting that Q3 2023 GDP will be 4.9%, a notable reacceleration from 2.1% in Q1 2023 and 2.2% in Q2 2023. A survey of economists is more pessimistic than the Atlanta Fed estimate, at 3.0%.
• September jobs will be reported on October 6. Nonfarm payrolls have been decelerating for several months but have remained surprisingly resilient.
• Student debt payments will restart October 1.
• Equity volatility: The S&P500 is up 13.1% year-to-date, and October is historically a volatile month. We would not be surprised to see continued volatility in October as the market digests the conflicting signals of strong corporate earnings growth and a strong labor market against continued concerns about rising rates and another possible government shutdown.

Markets earned their reputation for late summer volatility this year, with equity returns down in both August and September. Breadth remained elusive, with large-caps significantly outperforming small- and mid-caps. Bonds too saw negative returns for the month as yields rose. Despite its notoriety for crashes (1929, 1987, 2008), October is also known as a “bear killer,” or the month when weak markets stop declining. At present, we assess economic data as tilting positive and prefer equities over bonds.

The Consumer May Be at Risk of Slowing Down as We Enter 2024

This month we re-visit the health of the US consumer. Consumer spending represents two-thirds of GDP; the strength of the consumer has underpinned the strength of the US economy for the past three years. This was initially driven by large COVID-era stimuli, some of which was spent and some of which was saved. Empirical Research Partners, LLC estimates that at the peak, US households had $3.3 trillion of “excess savings” – savings above the pre-pandemic trendline.

To assess the health of the consumer, we look at income (average hourly earnings both absolute and compared to inflation). We also look at Fed data on household spending. Differences between income and spending are reflected on the household balance sheets. We also look at credit card borrowings and examine whether consumers are beginning to show stress, as measured by credit card delinquencies. We close by looking at consumer confidence.

• Wages: While average hourly earnings increased ahead of core inflation for 2021 and 2022, wage growth has fallen behind core inflation for most of 2023. (source: Federal Reserve, BEA, Bloomberg)

• Consumer spending: Federal Reserve Bank of St. Louis data on consumer spending shows that personal consumer expenditures have continued to grow, rising an average of 6.4% on a year-over-year basis so far. So, despite average hourly earnings not keeping up with inflation, consumers are still spending.
• Household balance sheet: The consumer has spent down most of the so-called excess savings. Federal Reserve aggregate household balance sheet data reveals that household deposits, after having swelled during COVID, have stopped growing and, in fact, have declined by 3% in each of Q1 and Q2 2023.
• Credit card balances: The consumer has been increasing credit card debt to fund spending. During 2020 and the first half of 2021, consumer credit card balances declined, but since the middle of 2021, they’ve been increasing, and are now back on the pre-COVID trend.

• Credit quality: Credit quality amongst consumers has deteriorated in recent months. Here is a graph of cards delinquent by more than 30 days.

• Consumer confidence: As measured by The Conference Board, consumer confidence has remained steady over the past several months.
• Student debt repayment: The COVID-era suspension of student debt repayments has ended, and student loan repayments must resume October 1. Approximately one-fifth of American adults have student debt outstanding, with an average payment of approximately $300/month.

What does this all mean?

The consumer, which has driven stronger-than-expected GDP over the past three years, may be at risk of slowing down as we enter 2024 due to the confluence of excess savings having been depleted, wages no longer keeping up with inflation, and the resumption of student loan repayments. We are seeing this increased stress on US households in real time, both in growing credit card balances and in higher 30+ credit card delinquencies. Note that delinquencies remain well below distressed levels.

Consequently, the support that higher consumer spending has been providing to GDP may weaken. This could be offset by accelerating spending in the corporate sector. This may very well occur, due to fiscal incentives provided in the Inflation Reduction Act ($40 to $100 bn per year depending upon uptake of the incentives), the CHIPS Act of 2022 ($50bn), and the trend toward re-shoring. As one example, consumer spending added 2.5% to Q1 2023 GDP while fixed investment added 0.5%. In Q2, consumer spending was softer, adding 0.5% to GDP, while fixed investment added 0.9%.

All else being equal, this slowing consumer may help the Fed in its inflation fight. The market is pricing in one more rate hike – a weaker consumer could support a pause thereafter. This would be bullish for bonds as it could signal an end to the hiking cycle. Within equities, the weaker consumer points to shifting allocations away from more consumer discretionary areas and perhaps toward sectors such as industrials.

Disclosures