Our Top Market Takeaways for October 6, 2023

Market update: Rate riot

Every volatile period in markets has a main character. During this episode, it has been U.S. Treasury yields. Interest rates on 10-year U.S. government debt spiked to a 16-year high of nearly 4.9% this week before settling down to 4.7% by Friday morning. 


Treasury yields are like the foundation that the rest of financial markets are built on. When the foundation is shaking, it is hard for other segments to find their footing.

For example, the S&P 500 is about 8% below its year-to-date high reached on July 31. U.S. small caps are down nearly 14%. The utilities sector, which is often viewed as a “safe-haven” given its highly consistent revenue profile, is down over 15%.

European equities have been able to hang in a bit better (-6% since the end of July), but are still unnerved by the bond market move (10-year German yields are up by 33 basis points since the end of September).

So what is behind the move in rates?

Let’s start with the fundamentals.

Growth: Third quarter U.S. GDP growth was probably 3% or higher, and there is growing evidence that the durable tailwinds to the economy are being underestimated. The latest revisions to U.S. GDP data released last week showed that construction spending on manufacturing facilities is up 75% from the pre-pandemic pace. Before the revisions, the data suggested that it was “only” up 40%. This surge is likely due to U.S. industrial policy, and could last for a few more years.

Monetary Policy: Because growth has been resilient, the Federal Reserve is no longer expected to be lowering interest rates any time soon. The first Fed meeting where markets think the most likely outcome is a rate cut isn’t until June of 2024. 

And now for everything else:

Fiscal deficits: The Treasury is likely to issue more bonds in the future to finance the deficit, which all else equal should increase bond yields.

Washington dysfunction: The drama in the House of Representatives does not help dispel the perception that the government lacks the composure to deal with important longer-term issues around its own finances.

Technical market factors: Positioning, momentum and trend-following strategies could all be exacerbating the moves.

What happens next? We expect rates to stabilize, and eventually fall. Here is why. 

Growth should slow down: We see a few clear headwinds that lead us to expect a deceleration in the fourth quarter: the restart of student loan payments, a reversal in momentum for the housing sector, a potential government shutdown and stagnant capital markets should weigh. Into 2024, higher interest costs continue to roll through the economy. As interest costs take up a higher share of income for corporations and consumers, it diverts their ability to invest in capex, make new hires, and spend on discretionary items. Real policy rates are on track to surpass real growth over the next two quarters. In the five other instances we have observed since 1980, growth slowed within three quarters in all but one of them.

Inflation is still decelerating: Inflation, as measured by the Fed’s preferred metric, hit 3.9% year-over-year (YoY) in August, a 27-month low. While above the Fed’s target, under the surface we have seen a sharp deceleration. The three-month annualized rate of change in core inflation was 2.2% in August. A slower pace of growth should keep that on track.

The Fed remains on hold: Weaker growth and inflation trending towards target should keep the Fed on hold from here. Historically, yields across the Treasury curve head lower after the end of the Fed’s hiking cycle. We think this pattern will hold; the market just needs clarity that the Fed is actually done. 

Today’s labor market data was strong, but wage growth was not a concern. The inflation focus will be on next Thursday’s Consumer Price Inflation release. But if things progress as we expect them to, markets should settle down up.

Investment implications: What can you do about it?

We see three clear takeaways for investors: bond yields suggest attractive returns, the equity market dip is providing an entry point and we still feel great about multi-asset portfolios.

Bonds look attractive. Treasury bond markets have gone a long way towards pricing out a recession and compensating investors for additional uncertainty. Markets are assuming that policy rates will remain above 4% for the next 10 years. We think this rate is probably too high. That suggests that longer-dated bonds have value. In the municipal space, we are starting to see more issues that have a 5% coupon trade at par value. This has only happened three times in the last 15 years and has consistently provided a ceiling for municipal yields.

As do equities. Earnings expectations are still climbing, while the drawdown has brought valuations back in line with the 10-year average level. From here, we think earnings season (which starts next Friday), positive seasonal trends and stabilizing bond yields will help equities start to rally again. Looking out, we think the chances are better than not that the S&P 500 makes a new all-time high by the middle of next year due to decent earnings growth and valuation expansion as inflation fades further.

Finally, we think that multi-asset portfolios are well positioned to deliver for investors. Equities provide the upside potential in the case that our view plays out, or we end up getting into a bull case where in 2024 equities surge because inflation comes back down to 2% and the Fed is lowering interest rates. Meanwhile, fixed income can provide the protection that we rely on in case growth slows more dramatically than we expect. If a recession does happen, it seems like interest rates would be poised to fall, and investment grade bonds could rally. If our view plays out, fixed income yields are at levels that suggest healthy total returns even if nothing changes. From here, both parts of the traditional 60/40 portfolios are poised to continue to do their jobs for investors (a global 60:40 stock:bond portfolio has returned nearly 5% year to date, while a U.S. 60:40 has returned nearly 7%).

Market sell-offs can be painful for those who are already invested, but we would encourage those folks to remember their plan. Perhaps the right course of action is to acknowledge that volatility is normal and that you are still on track to reach your goals. For others, a conversation about the options that higher bond yields provide to achieve similar returns with less risk could be appropriate. Yet another group may look at the sell-off in equities and see an opportunity to add exposure to portfolios, like we do.

No matter you and your family’s situation, your J.P. Morgan team is here to discuss opportunities we see in the context of your overall plan.

All market data from FactSet and Bloomberg Finance L.P., 10/6/23.

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