September 2023 Stonemark Market Commentary

As we approach the homestretch of 2023, it has been a tumultuous year so far, with several ups and downs. From talks of a hard landing to a soft landing, and even no landing at all, to a banking crisis, debt ceiling showdown, and the uncertainty surrounding a possible recession, the first nine months of the year have been quite eventful. Moreover, the recent government shutdown debate has added to the list of challenges. Despite a promising first half, driven by growing excitement over artificial intelligence and its future potential, equity markets have returned to earth.

September has historically been a weak month for the S&P 500, with an average loss of 0.7% since 1945. This year followed the same pattern, with the index falling 5.4% and ending Q3 down 3.9%. Financial markets struggled as investors adjusted to the new regime of higher interest rates and greater volatility, which Fed Chairman Powell echoed during his press conference at the September 20 FOMC meeting. Though the Fed decided not to raise interest rates, their economic forecasts and interest rate projections shifted sentiment meaningfully toward risk-averse assets. Mixed data for the month complicates the outlook for markets and the economy.

On September 13, the Bureau of Labor Statistics released August's Consumer Price Index (CPI) report. The report revealed that headline inflation had increased year-over-year to 3.7%, which was a slight surprise and a jump from the previous month's figure of 3.2%. This increase was mainly due to the rise in energy prices, which are beyond the control of the Federal Reserve. However, the more important core CPI number, which excludes food and energy, continued to trend downwards, coming in at 4.3% year-over-year compared to the previous month's figure of 4.7%. Despite the increase in energy prices, they are still considered deflationary when looking at the year-over-year data due to the significant decline in natural gas prices. Energy prices may become a more significant factor in future inflation reports if we experience a cold winter or geopolitical events push oil prices higher.

Despite ongoing disinflation in the economy, it is difficult to predict the exact point at which it will bottom out. Inflation may reach a standstill above 3%, in which case further action from the Federal Reserve may be necessary. Alternatively, if the prices of essential items continue to decrease, the core target of 2% may be achieved. However, hoping for a rate cut or a pivot is wishful thinking at best.

The US job market improved in August as 187,000 new jobs were added. However, the unemployment rate rose to 3.8%, and wage growth slowed. This suggests that the labor market may be easing and supports the decision of the Fed to pause any interest rate hikes. In the past quarter, job growth has averaged 150,000 per month, which is significantly lower than the 238,000 jobs added in the three months through May. Even though 222,000 people found employment in August, it was not enough to accommodate the 736,000 new entrants to the workforce. As a result, the unemployment rate reached 3.8%, the highest since February 2022. The Fed's latest median estimate of the jobless rate for the fourth quarter of this year is 4.1%, which is still higher than the current rate. The rise in unemployment was particularly noticeable among young adults.

The Conference Board's Leading Economic Indicators (LEI) report, which combines 10 forward-looking economic indicators, was released on September 21st. The report suggests a recession is imminent, as the leading indicators have fallen for the seventeenth consecutive month in August. The leading index was negatively impacted by weak new orders, deteriorating consumer expectations of business conditions, high interest rates, and tight credit conditions. All these factors indicate that economic growth will likely slow down and experience a brief but mild contraction. According to The Conference Board, real GDP is expected to grow by 2.2 % in 2023 and then decline to 0.8 % in 2024. If the LEI continues to remain negative, there is a greater chance that investor optimism has been misplaced, and we may be heading towards a severe recession in 2024 with prices headed downwards.

As we enter the final quarter of 2023, it is striking that the terrain has remained largely unchanged over the last nine months. The two major uncertainties investors grappled with at the beginning of the year - persistent or subsiding inflation and the possibility of a recession - remain unresolved. However, the market has behaved unexpectedly, with stocks mispriced, resulting in a significant divergence between the S&P Top 50 stocks, the S&P 500, and the equal-weighted S&P 500. Value investors who primed their portfolios for an economic downturn were left behind as the market rallied, leading to the S&P 500 approaching within 4% of its all-time high of 4,796. This happened even though the economy experienced three out of the seven largest U.S. bank failures in three months.

However, the market has taken on a different disposition since mid-July, and second-quarter earnings season proved to be the perfect moment to take in profits. In retrospect, this makes sense given the weakening earnings quality and negative year-over-year growth for many industry groups, coupled with the strong price run-up in mid-July, which extended valuations. Third-quarter earnings are also expected to decrease by 0.2%, leading to more nervousness. As valuations remain elevated, still at 18x earnings, investors should expect a further convergence of the Top 50 stocks with the overall S&P 500 and the S&P 500 Equal Weight as underappreciated assets see positive gains.

At the beginning of the year, inflation and the possibility of a recession were top of mind. This topic has come up repeatedly and has left investors feeling exhausted. Unfortunately, it is unlikely that either issue will be resolved soon. The market is expected to keep swinging between two extremes. On the one hand, there could be a time of great optimism where inflation is no longer a concern, and the economy has a smooth landing. On the other hand, there may be a time of extreme discouragement where inflation returns in full force, leading to a recession. Additionally, unexpected news from Washington D.C. could also negatively impact the market. As is often the case, the truth will fall somewhere in the middle, but it will not be easy to find.