At the end of October, we wrote a newsletter talking about the unusual 3-month decline seen in the S&P 500 in August, September and October. You can read that full report here. The basic message in that report was that we believe that the market narrative had shifted overwhelmingly to interest rates, inflation and the Federal Reserve (Fed). Economic performance, such as strong employment, decent corporate earnings and a robust Gross Domestic Product (GDP) for the third quarter of 2023 didn’t seem to matter. Bonds also continued their slide during those three months, this after a terrible year for fixed income in 2022. The bond recovery we had been expecting wasn’t showing up. Investors were justifiably frustrated by the end of October.
Then came November and the Fed had its monetary policy meeting and the overall picture improved. The Fed decided to hold interest rates at current levels, with no increase. During their press conference, the Fed illustrated that inflation appeared to be moving in the right direction and that further rate increases may not be needed. This was a relief to markets which was then further supported by the October Consumer Price Index (CPI) reading of +3.2%…down from the +3.7% amount in September. Granted 3.2% is still well above the Fed target of +2.0%, but a -0.5% drop from September seemed encouraging. Markets responded to this in a very positive way. From the low point at the end of October, to month-end November, the S&P 500 was up about 10%. Bonds also responded favorably with the Bloomberg Aggregate Index up about 4.6%. Not as strong as stocks, but a respectable run for fixed income. Why is this, and what do we think happened?
If we were right about what was happening in August, September and October that the market narrative was fixed on interest rates, inflation and the Fed, then what changed? We believe that markets were unwilling to see the improvement seen with inflation since the Fed started raising rates and trying to cool the economy. Yes, September inflation came in at +3.7% and that was a disappointment, but that level is still miles away from the +9.1% inflation seen in June 2022. We believe the economy is slowing and that the evidence was that the Fed was winning their battle with inflation. The Fed left, and continues leave, the door open to further rate increases and we believe the markets were somewhat convinced that another rate increase was coming. But the better October inflation reading, and the more positive November Fed press conference seems to have shifted the markets to thinking we will not see another rate hike. Rates don’t have to go down for markets to start being more bullish, but they definitely can’t go up. Thus, we believe the market narrative has shifted to one where we likely won’t see another interest rate increase, inflation has moderated and the idea of interest rate reductions in 2024 is looking more likely. This shift has started the investment buying in both stocks and bonds that has created the November rally. The story then got even stronger with Fed December meeting on the 12th and 13th where the conclusion continued to be that inflation was improving, rate increases were likely not necessary and, to the surprise of many, the idea of interest rate cuts was actually mentioned. We believe this further supports the market narrative shift away from inflation, interest rates and the Fed.
The second estimate for the third quarter GDP came in at +5.2% an increase from the initial estimate of +4.9%. This is a very strong GDP reading for an advanced economy like we have in the U.S. It doesn’t indicate that the Fed’s interest rate increases have slowed the economy and that does detract from the overall sentiment of lowering inflation. But we believe that the manufacturing recovery happening in the U.S., along with strong employment numbers, and increasing wages is enough to push GDP up even though we are seeing price pressures reduced. There’s no guarantee we will get inflation back to the 2.0% Fed target, or that we won’t see recessionary pressures, but the overall story does seem to be improving. The Fed is rightfully concerned that if they start lowering rates too soon or too quickly, inflation will ramp back up. But clearly, they are thinking about rate cuts and how to start moving rates closer to normal. This is the new narrative from our view. If the market continues to think we are beating inflation and we will manage the so-called soft landing of breaking inflation without a recession, then markets will continue to go up. We could see a full recovery back to 2021 levels during 2024. But, the risk here is that inflation doesn’t slow as expected and rates get held higher for longer, or worse yet, another rate increase happens and then all bets are off with what the market will do. Our base case is that we think this new narrative is closer to reality and that we can execute the soft landing. The underlying economy is strong as outlined in the last newsletter and we believe the Fed is winning the inflation battle. The November press conference did some of the reassuring we stated needed to occur and then continued that same reassurance in December. Although it won’t be a straight line up, we think the markets from here will continue to improve for both stocks and bonds. The story is getting better, and we believe the markets are finally starting to believe it.
All the best,