The calm before the October storm

09/18/2023 — Equity markets were little changed in a quiet week, continuing the sideways zig-zag pattern in which the S&P 500® Index has been since June. Volatility remains muted, though Friday saw the first directional move of more than 1% for the S&P 500 this month. Last year, half of trading days had moves of greater than 1%, while that number is roughly one-quarter this year, and since March it is one in seven. The VIX touched the lowest level since before the pandemic. The positive and calm market in the face of potentially market-moving inflation data reinforces the idea that investors are less emotional and reactionary to macro news than they were a year ago. Midway through September, the S&P 500 is down less than 1%, which is better than the historic average. While seasonal patterns and the lack of emotional selling are strong omens for the fourth quarter, clouds developing for the consumer, labor market, and margin pressure are critical to monitor.

On the 15-year anniversary of the Lehman Brothers collapse, investors continue to allocate to cash, with money market funds attracting $1 trillion of inflows year to date, on pace to break the record set in 2020. It is unclear what percentage of the flows is a parking place to de-risk portfolios, and how much is an allocation decision with rates above 5%. The Bloomberg® US Aggregate Bond Index has currently returned just 0.5% this year and yields just 3%, setting the stage for an unprecedented third-straight losing year in the bond market. This performance gap is challenging investors’ commitment to historical asset class allocations. Hedge funds are becoming increasingly cautious, adding to short positions in five of the past seven weeks, per Goldman Sachs.

Heading into October, there are three externalities for investors to watch, including a government shutdown, potential challenges with student loan repayments and continued union strikes. These three factors – along with uncertainty from the Fed amid the upcoming FOMC meeting and earnings kicking off – are likely enough disruption to make some investors believe we are heading for volatility. However, historically over the past 40 years, the six months following a government shutdown were positive for the market each time. Though correlation is not causation, there’s reason to believe a future shutdown would have a similar response. Additionally, the fact we have not seen strong market reactions to any recent challenges is further evidence that these externalities will not become pervasive economic issues.

News

The labor market is facing challenges, with the United Auto Workers strike and the looming government shutdown the latest concerns. After failing to make a deal on Thursday, the UAW called for a strike against the Big Three automakers, though the initial phase is only at one plant per company. If talks do not progress, the strike will expand. The union is asking for a 36% wage increase over the next four years, roughly double the offer from the companies. Bank of America estimated that a full stoppage for a quarter would be a 2% hit to GDP (0.1-0.2% per week). This would put upward pressure on used car prices, reigniting inflationary pressure. There has been no progress in negotiations in DC to avoid a government shutdown with the deadline two weeks away. Freedom Caucus members of the GOP are limiting the ability of Speaker McCarthy to work a deal. Goldman Sachs estimates that a shutdown of two or three weeks would be a 0.6% hit to fourth-quarter GDP. Government shutdowns historically have not been a challenge for equity markets. In the seven shutdowns over the past 40 years, the S&P 500 has been positive in the following six months in each of the seven occasions, by an average of 14%. The bond market could see volatility, as the US Treasury will need to pre-fund in September, as it cannot issue when the government is shut down.

Inflation data this week was a reminder that the path to the Fed’s 2% target is challenging and uneven, with consumer price inflation reaccelerating to a higher-than-expected 3.7% from 3.2% in July and 3.0% in June. This followed 12 straight sequential improvements. Energy prices were the primary pain point, with gas prices up 11% sequentially. Excluding food and energy, core CPI was in line with estimates at 4.3%, down from 4.7% in July. Strong wages are beginning to pressure inflation, with the Atlanta Fed’s "sticky CPI" (a basket of items where prices move slowly and are non-cyclical) jumped 5.3% from a year ago, with core up 5.2%, while flexible CPI rose just 0.4%. Inflation expectations per University of Michigan data are at the lowest level in two years at 3.1% for the next year and 2.7% over the next 5-10 years. Strategas Research studied inflation surges over time and noted that in only 13% of occurrences, prices didn’t have a second surge.

The ECB hiked the main deposit rate to a record 4% while lowering the economic growth projection to 0.7% from 0.9% for 2023, from 1.5% to 1% in 2024, and from 1.6% to 1.5% in 2025. There are increasing calls, including from Spain, Italy, and Portugal that rate hikes are overdone, though home prices and real estate investment are under intense pressure. Better-than-expected activity in China indicates a potential stabilization in the country, as the PBOC continues to take policy actions to drive growth.

What to watch

The FOMC meeting this week will be the primary focus of investors. There is little chance of a hike, but economists will look for a signal for November. Economic data includes housing starts on Tuesday, leading indicators on Thursday, and PMI data on Friday.