By Ellen Hazen, CFA®, Chief Market Strategist

September 30, 2022

September Takeaways:

• Inflation, while easing, remains higher than the Federal Reserve’s 2% target. The August CPI of 8.3% Y/Y declined from July’s 8.5% and June’s 9.1%, but remains uncomfortably high. In response, the Fed raised the Fed Funds rate by another 0.75% in mid-September, to 3.25%.
• As a consequence of relentlessly rising interest rates, volatility spiked across all asset classes during September. Equity markets declined in many parts of the world, with the S&P500 down nearly 8% in the month, the FTSE 100 down 5%, the Euro STOXX down 6%, and the Nikkei down 7%.
• Fixed income markets had an even more volatile month than equities: the 10-year US Treasury yield spiked from 2% to over 4.0%, before easing a bit at month end. The 10-year UK government bond increased from 2.8% to 4.5% before easing a bit as well.
• The US labor market continues to be unusually strong: August unemployment remained very low at 3.7% (July was 3.5%), and initial jobless claims continue to come in lower than expected, averaging 207,000 per month.
• Rising interest rates have slowed activity in housing and other durable goods, however, demand for services remains strong, which is buttressing the labor market and the overall economy.
• Both bottom-up and top-down analysts are beginning to reduce S&P500 earnings estimates, but likely not yet enough. The 2022 estimate has declined from $228 per share (10% growth) to $224 (9% growth), while the 2023 estimate has declined from $249 (9% growth) to $239 (6% growth). Historically, in recessions, earnings contract, rather than grow.

We expect continued volatility across markets as a result of synchronized central bank tightening. Banks from the Bank of England to the European Central Bank to the Bank of Canada are raising their benchmark rates.

We expect earnings estimates for 2023 to continue to decline as the Fed continues to tighten monetary policy, driving a slowdown in the economy. Despite this, we believe the strong labor market will continue to undergird the US economy, somewhat ameliorating the slowdown in demand for durable goods.

What We Are Watching for in October:

• Q3 earnings reporting season begins in the second week of October. We’ve seen negative guidance from a number of off-quarter reporters, including Federal Express and Nike. We fully expect companies to guide down for 2023.
• September unemployment will be reported on October 7 – we expect the unemployment rate to be flat to slightly up from August’s 3.7% level.
• Europe is keen to import as much liquefied natural gas (LNG) as it can from the US, given disruptions to Russian supply. US exports have been crimped by the shutdown of the Freeport LNG facility in Texas. When this comes back online, expect more natural gas to be exported to Europe, which may drive higher natural gas prices domestically.
• The Inflation Reduction Act (signed into law in August) is a game-changer for US industrial companies and utility companies, among Our forthcoming quarterly newsletter will have additional details on this. We will also be listening to what companies say about their IRA opportunities on their Q3 earnings calls, and anticipate additional investment opportunities to emerge.

The investment world is starting to reflect what the end of four decades of easy money may mean for asset valuations. In September, we saw higher volatility in nearly every asset class, from commodities to foreign exchange to equities to bonds. On top of the higher volatility, correlations among asset classes increased, with most asset classes declining in tandem.

Globally, long-term interest rates have – until recently – been declining for decades. Investors and businesses have responded to these low rates by increasing leverage in a wide variety of ways. As interest rates climb, leverage will decline, causing many asset classes to revalue.

Central Bank Tightening: Everything, Everywhere, All At Once

The month of September was a volatile one across all asset classes. The US equity market declined by nearly 8%, and the equity volatility index (“VIX”) increased above 30, toward the high end of values seen over the past decade. The treasury volatility index (“MOVE”) has been trending markedly higher all year, and nearly reached the peak of 2020.

Our financial system is, quite rationally, built on a foundation of leverage. Banks lend out money they’ve borrowed from depositors. As long as investors and depositors retain confidence in the system, this recycling and multiplication of money works well: people can borrow to purchase a home or start a business, growing the economy. This is why bank regulation is so important: the system is inherently built on confidence. We saw what happens when there is a lack of confidence in banks in Frank Capra’s classic movie It’s a Wonderful Life: there is a run on the bank, and the economic activity stops.

Banks were at the heart of the 2008 financial crisis, but they are in sound condition today, thanks to increased regulation and capital requirements. (I will not argue that every one of the changes were necessary, but rather that they collectively have led to a strong banking system today).

Expect the Unexpected

The shadow banking system – non-bank lenders, which is by its nature less regulated – has grown to lend where banks cannot or will not. The excess liquidity that has resulted from very easy monetary policy has a way of

seeping into unexpected areas. This week, the Bank of England unexpectedly stepped in to support the UK government bond market after pension funds – which had leveraged up in order to boost what had been slender fixed income returns – began receiving margin calls. Some UK pension investors borrowing at up to 7:1 – who knew?

As interest rates have risen, business models that were predicated on easy access to low-cost debt, such as private equity, no longer work, or at least no longer work to the same degree that they had in recent years. As long as inflation remains above the Fed’s 2% target, the Fed will continue to raise interest rates. As long as the Fed continues to raise interest rates, we will see more cracks in these business models, which may bleed into the real economy.

Some Parts of the Economy Are Sensitive to Higher Interest Rates

As we know, the Fed is trying to tame inflation by tightening monetary policy. This is taking two forms. First, the Fed has raised the overnight Federal Funds rate from 0% in March of this year to 3.25% through increases at five consecutive meetings. Current market expectations are that the Fed Funds rate will increase to over 4.0% by the end of 2023. Second, the Fed is letting its balance sheet roll off. Recall that the Fed has actively increased its purchases of long-term debt since the pandemic, and its balance sheet now stands at $8.4 trillion. The Fed increased its runoff pace from $47.5 bn per month to $90 bn per month starting in the month of September.

The 10-year Treasury has in turn reached its highest level since 2010.

The transmission mechanism through which higher interest rates tame inflation is by reducing demand. (As many have observed, the Fed cannot unsnarl supply chains or manufacture semiconductors). This works particularly for items that are financed: autos and housing. We have seen weaker auto sales thus far in 2022 – the average annualized rate has been 13.6 million autos, down from 14.9 million in 2021. Some of this may be due to supply constraints, but some is due to higher financing costs. We have also seen weaker housing demand due to higher mortgage rates. The prevailing 30-year mortgage rate has nearly doubled, from 3.3% at December 2021 to 6.5% today. New housing starts for August (seasonally adjusted) are down more than 12% from the peak earlier this year.

We are in a relatively privileged position in the United States, with easy availability of a 30-year fixed rate mortgage. Because many people bought or refinanced when rates were lower, the average rate locked in for American homeowners is currently about 3.5%, compared to 6.5% for a new mortgage. United Kingdom residents are not so lucky: most mortgages there are floating-rate, with perhaps a 2-year or 5-year fixed period. In the space of just two months, the 2-year UK bond yield has increased from 1.7% to 4.7%, significantly impacting UK borrowers. In addition, higher US rates are translating to a strong US dollar, effectively causing other countries to import inflation.

Corporate Earnings Estimates Have Begun To Decline, But There Is Likely More To Go

Earnings estimates for the S&P500 remain likely too high for 2023. Currently 2022 estimates have declined a touch, from $228 per share to $225. Estimates for 2023 have come down as well, from $249 back in June to

$239 now. However, $239 is still likely too high. With corporate margins likely to compress due to rising labor and other input costs, and revenue softening, we expect that earnings may be more likely to be flat in 2023.

The Silver Lining

All is not bleak, though. First, higher interest rates mean that our clients can, for the first time in years, earn competitive returns on fixed income investments. Today, a client can buy a high-quality, A-rated corporate bond and lock in a 4.7% yield if it has a 2-year maturity, a 5.0% yield at 5 years, or a 5.3% yield at 10 years.

Because our clients’ assets are not leveraged, they are not directly exposed to this leverage unwind. They do not run the risk of margin calls, as some of these other business models do. And we have long since reduced or eliminated client exposure to riskier areas of the market, including emerging market equities, international small companies, and high-yield bonds.

The unwinding of leveraged business models will likely take quarters or years. We expect to see continued surprises in areas that were not widely thought to be leveraged, and which cannot handle higher interest rates. At the same time, the US economy is fundamentally in fairly good shape, with a strong jobs market and high corporate profitability. This deleveraging will hit those corners of the market that were built on leverage, even as other parts of the economy continue to function relatively smoothly.

Sentiment in the US equity market is uniformly negative. The chart below shows the Ned Davis Crowd Sentiment Poll, which illustrates how bearish investors have become. This could lead to a sharp bounce in markets, despite headwinds. Expect the unexpected, and keep those seatbelts fastened.

Click to Enlarge 

Disclosures