September Stress
Equities have weakened and interest rates have risen since the end of July. Pro-cyclical stocks have sold off much more than the broader market – perhaps anticipating economic weakness in the next six to eighteen months. But crude oil and gas prices have continued to rise just when the Fed was thought to be close to being done raising rates. Should investors be concerned or is this normal seasonality for the markets?
The rise in interest rates has been very sharp since April. The 10yr and 2yr Treasuries have risen by 112 and 133 basis points, respectively. The 10yr rate of 4.43% is at its highest level since October of 2007 while the 5.11% 2yr note is at its highest level since July of 2006. And mortgage rates are now at about 7.30% after starting the year at about 6.50%. Why have rates moved up this much over the past several months? The straightforward answer is the consumer and the economy remain remarkably resilient and the prospects for recession have receded. On the shorter end of the curve, the move higher in the 2yr is the market anticipating a Fed that may have to raise rates further to curb the stubborn inflation now rather than later.
This higher interest rate environment is starting to have an impact on the economically sensitive parts of the market. Since the end of July, semiconductor stocks are down about 13%, retail stores and housing related stocks are down over 11% each, whereas the S&P 500 is only down about 5.6%. This is the market anticipating a slowdown looking out over the next six to eighteen months and it usually shows up first in these pro-cyclical areas.
And yet, crude oil is up 31% since May. Gasoline prices are up 25% since December of last year. Oil’s move higher is largely due to the purposely reduced production of Saudi Arabia and Russia. China’s demand for oil hasn’t been a driver for the higher prices, as its economy is soft. Nonetheless, the Fed tends to look past this type of supply shock as being transitory. The higher fuel prices and the resumption of student loan payments in October could mean we see lower discretionary spending over the next several months and this lower consumer spend in turn could perhaps lessen the need for further interest rate hikes, at least at the margin.
To go along with the higher energy prices and student loans resuming, we also now have the UAW strike that threatens to get larger and more impactful over the next few weeks. The threat of a shutdown of the government also lurks in the background. It’s never easy and the market always has multiple things that to worry about. So, this market is no different.
It’s worth noting the S&P 500 is up nearly 14% year to date. The consumer remains employed and in relatively good shape. We’ve just experienced the fastest interest rate increase in over forty years and the economy, unemployment, and the consumer have weathered the storm to date. Another interesting observation about the consumer is that Amazon announced that they will hire 250,000 seasonal employees for the 2023 holiday season. In 2022 they hired 150,000 and in 2019 (pre-Covid) they hired 200,000. One must assume that they have some decent data on the consumer and are hiring accordingly. These facts are hints that the interest rate hiking cycle may not be done yet.
The S&P 500 is currently trading at 20 times (12-month forward) earnings and could be considered somewhat expensive given where the Fed has interest rates and the higher for longer scenario. However, the VIX and MOVE volatility indices both are low and not showing signs of stress. Nor are credit spreads. Moreover, investment grade and high-yield spreads remain low and orderly. Volatility indices and credit spreads would likely be showing signs of concern if this market’s price action was developing into something significant on the downside.
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