September 2023 Market Commentary
September 18, 2023
Markets, as measured by the S&P 500, enjoyed a strong start to summer, gaining a cumulative 10% in June and July on increased optimism that the Fed might achieve an elusive soft landing. August, however, saw the S&P 500 pare some of those gains, due in part to rising interest rates. At the short end of the Treasury yield curve, higher rates were prompted by increased expectations of an additional Fed rate hike before year end, while at the long end of the curve, higher rates resulted from updated projections of economic growth and renewed concerns over the national debt.
Those concerns were exacerbated in early August when ratings agency Fitch downgraded the United States’ credit rating from AAA to AA+. The company cited several factors for its decision, including expected fiscal deterioration over the next three years, a high and growing government debt burden, and the erosion of governance over the past two decades resulting in repeated debt limit standoffs and last-minute solutions. The downgrade lacked the shock factor of Standard & Poor’s similar downgrade in 2011, and elicited a far smaller response from equity markets, but nonetheless placed upward pressure on interest rates and downward pressure on equities.
Economic data released during the month reinforced the notion that US economic growth remains modest, if not robust, defying many economists’ predictions made earlier in the year. Highlighting the increased optimism surrounding the economy, both JP Morgan and Bank of America retracted their prior forecasts calling for a recession in 2023. Additionally, staff economists at the Federal Reserve also no longer see the economy headed for recession. Instead, they now expect a noticeable slowdown in growth, but not a recession, starting later this year. Current data suggest such a slowdown is unlikely to happen before the fourth quarter. According to the Atlanta Fed’s GDPNow forecasting tooling, 3Q GDP growth is currently tracking at 5.6%, nearly three times the 2.0% growth recorded in 2Q23. While that estimate could change significantly between now and the end of 3Q, directionally it corroborates the general narrative that the US economy has remained surprisingly resilient thus far in 2023.
Highlighting that resiliency, nonfarm payrolls added another 187K new jobs in August. However, somewhat paradoxically, unemployment jumped 0.3% to 3.8%, its highest level since February 2022. The seeming contradiction was the result of 736K individuals entering the labor force in search of work, pushing the labor force participation rate to 62.8%, a new post-pandemic high, but still 0.5% below its February 2020 level. The higher participation level, and resulting increase in the unemployment rate, coupled with a decline in job openings, which fell to a nearly two-and-a-half year low in July, was likely welcomed by the Fed. All else equal, slowing labor market conditions should lessen the pressure on the Fed for additional rate hikes.
For the month, large caps (S&P 500) shed 1.8%, while small caps (Russell 2000) dropped 5.2%. International returns fared no better with developed (MSCI EAFE) and emerging (MSCI EM) markets falling 4.1% and 6.4%, respectively. Emerging markets were weighed down by disappointing Chinese data showing the country’s widely anticipated post-COVID rebound has failed to materialize as the country struggles with tepid consumer demand and a moribund real estate market weighed down by heavy debt burdens. In an effort to stimulate the economy, Chinese authorities announced a number of new measures, including reducing down payments for home buyers; encouraging banks to reduce rates on existing mortgages; increasing tax breaks related to childcare, education, and care for elderly parents; cutting taxes on stock trading; and reducing the amount of foreign currency banks must hold as reserves. As with most stimulus measures, it will take time to determine the efficacy of the new measures.
Like equity markets, higher rates placed downward pressure on bonds resulting in the Bloomberg US Aggregate Bond index, the broadest measure of the US bond market, losing 0.6%. Treasury yields experienced significant volatility during the month, climbing to multi-year highs, before ultimately ending close to where they began. At the short end of the curve the 3-month Treasury topped out at 5.48%, a high since 2001; the 2-year Treasury rose to 5.08%, a high since 2006; and the 10-year Treasury climbed to 4.34%, a high since 2007.
The 2-year rise was due to the market adjusting to the Fed’s “higher-for-longer” narrative, whereby the Fed eschews additional rate hikes and instead leaves rates at current levels for a sustained period. The 10-year climb was attributed more to growing concerns over the national debt and the ability of the Treasury to fund it. Complicating matters, the Fed is currently reducing the size of its balance sheet, curbing its appetite for government bonds at a time when the US Treasury is trying to fund a significant deficit. This creates a conundrum for the US Treasury and potentially a supply/demand imbalance in the Treasury market that investors are currently wary of. Markets are anticipating that yields will need to increase to entice buyers to purchase the new bonds the Treasury is selling to fund the deficit. As a result, yields on longer term U.S. government debt have risen.
Some of those fears were allayed near month end with the release of economic data showing job openings fell, consumer confidence slipped, Q2 GDP was not as strong as initially estimated, and PCE inflation continues to cool. The data supported assumptions that the Fed may be done raising rates, or at the very least will slow the pace of their hikes. As a result, yields fell back from their multi-year highs to close the month with minimal movement.
Similar to Treasuries, municipal bonds saw an upward climb in yields during the month, but unlike Treasuries, didn’t experience a drop-off at month end. Municipal bond yields typically lag Treasury market movements, so the month-end rally that Treasury bonds saw was not reflected in the muni market. However, if the Treasury rally holds into September, expect municipal bonds to move in that direction. Municipal bond prices year-to-date have held up well in comparison to Treasuries because of their own supply/demand dynamics. Municipalities have benefitted from stimulus and elevated tax receipts. With the increased funding, municipalities have not had to issue as much debt in this high-rate environment. That lack of supply has allowed muni bonds to push back on some of the pricing pressures caused by the Fed’s actions and outperform on the year.
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