Stock markets dropped for the second month in a row in September, closing out a weak quarter for financial markets. The U.S. indices were down in the mid-single digits, which brought markets to low-single-digit losses for the quarter and took the Dow below its 200-day moving average. International markets also pulled back for the month and quarter by roughly the same amounts. Even fixed income was down, with a substantial increase in interest rates. Financial markets were clearly in a risk-off mode.
Interest rates and inflation. What drove the weak performance were worries about interest rates and inflation. With economic news showing sustained growth and inflation still at historically higher levels, the Fed’s meeting last month resulted in a hawkish pause. Rates were unchanged, but Chair Powell recommitted to keeping rates high for as long as necessary. Rates crept up throughout the quarter, but the increase accelerated after the September press conference, taking rates to the highest levels since 2007. Markets now expect higher rates for a longer period.
The economy. That expectation has been anchored by strong economic news. The September jobs report showed an increase of 336,000 jobs, almost twice the expected level, along with strong upward revisions for the first two months of the quarter. Personal income and spending data continued to increase throughout the quarter, and business confidence and investment were solid.
Even with the continued growth, inflation continued to trend down last quarter. Despite that, the third quarter was a good one from an economic standpoint, which is part of what kept the Fed hawkish and drove rates up at quarter-end.
Potential headwinds. October and the fourth quarter may be more mixed for the economy. While job growth remains strong, other measures (e.g., quits and wage growth) are softening. External factors are also likely to weigh on growth, including the United Auto Workers strike, a potential government shutdown in November, the war that just started between Israel and Hamas, and other factors. While growth continues, the headwinds seem to be growing.
The Fed. As we move into the end of the year, the key issues will be whether growth continues and inflation keeps moving down. Market expectations on rates have changed rapidly. And if the Fed continues to act more hawkishly, that negative reaction could continue. That said, given that the underlying reason for the Fed’s hawkishness will be continued growth, any softening could lead to rates pulling back a bit. So, while there is risk here, there is also some opportunity.
Last month was a difficult one, taking us to losses for the quarter. Looking ahead, there are several economic risks. Because of that, growth may slow somewhat; if so, that should keep interest rates constrained. So far, the economy has managed to walk that tightrope pretty well, and that may continue in the fourth quarter.
From a market standpoint, we are also entering a better period. While September is historically the weakest month of the year, the fourth quarter has been notably better, which may be a tailwind moving forward. Overall, while September was a tough month for the markets, capping off a difficult quarter, the solid economic foundation and improving seasonal factors may give us better results through the end of the year.