Are We There Yet? Thoughts on the October Rally

Key Takeaways

• Despite the October rally, we believe investors should remain cautious and defensively positioned
• Market declines might not yet be over: The median drawdown of bear markets in the past 100 years is 34%; year-to-date, as of 10/31/22, markets have only declined 25%
• While driven by personal savings, strong labor market and past government stimulus, domestic consumer spending habits appear to be changing and consumer resilience may be dwindling
• Potential implementation implications:
  • Fixed income is finally generating meaningful yield opportunities without excessive risk
  • Long-term strategic targets should be reassessed as fixed income appears significantly more attractive
  • Potential opportunities are available in value and international equities via active managers
  • Look to harvest losses to offset potential capital gains and reposition portfolios to be more balanced and diversified

Volatility and Continued Wariness

After a challenging August and September, October provided a brief reprieve for equity investors, with the S&P 500 Index posting an 8.1% return (Source: Bloomberg). In our view, much of the rally was a reaction to overly bearish sentiment following late September’s turmoil in the United Kingdom coupled with negative positioning and the testing of key technical support levels for stocks.

Similar to our cautious view in the summer and early fall, we remain wary of this latest rally, as the market once again appears to have become overly optimistic that monetary tightening could be nearing an end. At its meeting last week, the Federal Reserve delivered its fourth consecutive 75-basis-point rate hike. This took the federal funds rate to a range of 3.75% – 4.00% and threw cold water on prospects for ending the current tightening cycle, while highlighting the risk of inflation. We expect continued upward pressure on rates and volatility in equity markets.

Looking for a Market Bottom

While it is tempting to hope that recent declines have hit bottom, a study of previous bear markets suggest that we might not be out of the woods yet. The median S&P 500 drawdown during bear markets over the past 100 years is 34% while the index has only declined 25% year-to-date, as of 10/31/22. Historically over the same period, the median time for the market to bottom during bear markets has been 17 months; currently, we are only 10 months out from the market's all-time high earlier this year. Past bear markets have also seen multiple rallies, and this year’s uncertain macroeconomic conditions are feeding into corporate earnings divergence and market volatility.

In addition, we believe that the current hiking cycle has yet to fully affect the economy—especially given the nearly unprecedented speed and magnitude of the rate increases. Since the 1980s, the median U.S. hiking cycle has involved increases of 3 percentage points over 15 months, while markets are currently expecting the Fed to raise rates by 5.15 percentage points over 15 months.

Usually, monetary policy takes a while to affect the real economy. Measured from the last interest rate hike in a given cycle, it has taken a median of 16 months for economic health to materially deteriorate (as defined by a drop in the ISM Manufacturing index to below 45), while Personal Consumption Expenditures (PCE) have started to meaningfully decline (defined by negative PCE growth over three months) after a median of six months. While the Fed may still engineer a soft landing (U.S. consumers continue to show resilience), the pathway is narrowing given the speed and magnitude of current tightening and the weakness of economic indicators such as housing, retail sales, consumer confidence and global Purchasing Manager indices. Potential economic deterioration going into 2023 is a major driver for our defensive views.

S&P 500 Earnings and the Consumer

We have been expressing our concern regarding overly optimistic consensus earnings estimates since midyear. With 85% of S&P 500 companies having reported, earnings for the third quarter have grown to 2.1%—their lowest rate in two years—with more than half of the sectors posting declines. Importantly, we have seen a bifurcation in earnings between the beleaguered Tech sector and more cyclical areas such as Consumer Discretionary and Industrials, which have managed to maintain earnings growth. However, consensus estimates continue to point to roughly 6% in overall estimated earnings growth for 2022 and 6% for 2023, levels that we believe to not fully reflect the potential economic impact of higher rates. In our view, this has created a misleading narrative that stocks have become cheap. In a typical recession (which has yet to officially be “called”), earnings have tended to fall by about 17%.

As for the domestic consumer, while sentiment has deteriorated materially due to rising prices for goods and services, strong balance sheets, boosted by three rounds of government stimulus payments and continued strength in the labor market, have provided some relief. However, we believe caution is still warranted as disposable income remains weak, potentially resulting in reduced spending. In September, real disposable personal income fell by 2.9%, suggesting that income may not keeping pace with inflation. Additionally, commentary from consumer-related S&P 500 companies suggests that a slight pullback by the U.S. consumer may already be happening as buyers opt to “trade down” by choosing less expensive goods and services. In the past three months, mentions of the term “trade down” on S&P 500 earnings calls have been three times the average over the past four years.

While higher interest rates may not have flowed into all parts of the economy, there are reasons to be somewhat optimistic about U.S. consumers. The labor market remains strong, with sustained, low unemployment claims and excess savings that are about $1.9 trillion above pre-pandemic trends, as of the end of August. We believe these savings are allowing many Americans to meet expenses as prices rise and real wages fail to keep up with inflation. The latest GDP report reflects this trend, with a 2.6% gain in Personal Consumption Expenditures (quarter-over-quarter, seasonally adjusted) contributing to growth. However, through August, savings declined at an accelerated pace—nearly $490 billion year-to-date—raising the question of how long consumers can remain healthy. Additionally, while household debt through consumer credit and mortgages has risen, debt servicing ratios remain low by historical standards, suggesting that the consumer still has some levers to pull in a deteriorating economic environment.

Silver Lining

It goes without saying that this year has been challenging for investors, but one positive resulting from this volatility has been the normalization of interest rates. In more than a decade since the Global Financial Crisis (GFC), low interest rates and the hunt for yield resulted in an uptick in credit and equity risk-taking across investor portfolios. Fueled by low rates, growth stocks handily outperformed their value counterparts and diversified equity portfolios lagged those with a heavy concentration in U.S. and growth stocks.

Now the tide may be beginning to turn. Investors are finally able to generate meaningful yield opportunities within their fixed income allocations without, in our view, taking on excessive risk. High-quality municipal bonds, for example, are now offering a taxable equivalent yield of over 6%. On the equity side, value-oriented stocks have outperformed growth by nearly 19 percentage points year-to-date as of 11/3/22, their strongest relative outperformance since 2000.

Though many risks are still on the horizon, signs of more market-friendly China COVID policies, along with historically low valuations for international stocks and a potential reversal in U.S. dollar strength (now at multi-decade highs) may present investors with attractive entry points in international equities in the near future. However, we believe investors should still exercise caution and consider active management.

We have seen active managers with additional insight into industries and companies navigate this challenging macro environment more effectively than passive investments, . The implications of this regime change could be significant. Given the run-up in equities since the GFC, many investors’ strategic asset allocations have skewed towards equities in seeking to generate returns in order to meet their goals and objectives. As we approach year-end, we believe clients should take a moment to reassess their long-term strategic targets in light of this potential yield backdrop, which has made fixed income appear significantly more attractive. Where practical, clients should look to harvest losses to offset potential capital gains and reposition portfolios to be more balanced and diversified.

Overall, we continue to encourage our clients to remain cautious heading into year-end despite the recent rally. Our positioning views remain broadly defensive and tilted towards higher quality assets within both fixed income and equity sleeves. Please reach out with any questions.