Stock markets dropped for the third consecutive month in October, with financial markets getting hit by higher interest rates across the board. The U.S. indices were down in the low-single digits for the month, which left the Dow and the S&P 500 below their long-term trend lines. International markets also pulled back by roughly the same amount. Even fixed income was down. Financial markets were clearly in a risk-off mode.
Interest rates and inflation. Worries about interest rates and inflation drove the weak performance during the month. With economic news showing sustained growth and inflation at historically higher levels, interest rates crept up. The U.S. Treasury 10-year yield topped out just above 5 percent, a decade-plus high. Strong growth pushed rate and inflation expectations higher. And as higher rates typically signal lower stock valuations, markets continued their decline.
The Fed. Last month’s Fed meeting was widely interpreted as a dovish pause, with rates unchanged and the commentary switching to a more “wait-and-see” tone as the economic data softened. Although still at a healthy level, job growth in November came in substantially slower than in October, and consumer and business confidence ticked down. Between the Fed meeting and the weaker data, rates have dropped significantly in the first week of November—and markets have rallied in response.
Earnings and fundamentals. While October saw higher inflation and rates, expectations for November are for slower (but still healthy) growth and lower rates. And that soft landing scenario is showing up in the data. Corporate earnings are coming in better than projected, and growth expectations are strong for the next quarter. With improving fundamentals and a better macro picture, markets may return to growth after three months of repricing. Looking forward, November and the rest of the year may be more positive for the markets.
The risks. Inflation may be returning in some sectors, and that will need to be monitored. The ongoing wars in Ukraine and the Middle East could be more disruptive than markets now expect, and domestic politics remain a concern. But with the fundamentals reasonably healthy and the macro picture stabilizing, many of the economic fears that pulled markets back in recent months may be subsiding.
Market trends. From a market standpoint, we are also entering a better period. While September and October are historically difficult months, the rest of the year is usually better, which is a tailwind moving forward.
As we move into the end of the year, the key issues will be whether growth continues at a slower rate and inflation continues to move down. Market expectations on rates have changed rapidly, and if the Fed continues to be more dovish, that positive reaction could continue. That said, given that the underlying reason for the Fed’s dovishness is continued slower growth and higher rates, any reversal of those trends could lead to rates rising again. So, while there is an opportunity here, there is also some risk.
And that is the bottom line here. We’ve had three difficult months, largely due to rising rates. Looking forward, there are signs that this trend may have peaked and started to reverse, which would be good for markets. While there are many economic risks, the trends are currently positive.
A Balanced Outlook
Looking forward, we seem to have several tailwinds. Growth is slower but still healthy. Rates are down, but so is inflation. Earnings are up, and valuations have stabilized. In all cases, we appear to have come to a balance between two opposite concerns. Right now, the economy is walking that tightrope pretty well, which may continue for the rest of the year. Looking back, we have seen a tough couple of months, but it’s possible that the coming months could be better.