“If it’s obvious, it’s obviously wrong.” – Joe Granville
September was a month of suffering for most of the financial indexes we follow. For the equity indexes, both US and international indexes posted negative returns for the month, with the US small cap and emerging markets indexes turning slightly negative for the year. The two bright spots – The US Dollar Index and CRB Commodities Index both posted positive returns.
All data as of 09/30/2023, Source: Wells Fargo Investment Institute. An index is not managed and not available for direct investment. Past performance is not a guarantee of future results. [Wells Fargo Investment Institute, Inc. is a registered investment advisor and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.]
In September 2023, the US stock market experienced what we would consider a significant downturn. The S&P 500, a benchmark for US equities, fell by more than 5%, marking its worst month of the year. The S&P 400 and S&P 600, indices that track mid-cap and small-cap companies respectively, also saw declines. In our opinion, this downturn was largely driven by concerns over high inflation and the Federal Reserve’s interest rate hikes.
At the same time, the bond market has also faced challenges. The US Aggregate Bond index, a measure of the performance of the US investment-grade bond market, saw a decline. This was largely due to a shift in investor sentiment from bullish to bearish, driven by the anticipation of central banks keeping interest rates higher for longer. The 10-year Treasury yield rose to its highest point since 2007, reaching around 4.64%.
Which leads us to our main topic this month: the rippling effects of short-term interest rate changes made by the US Federal Reserve Bank on the stock market and the bond market.
Interest Rates and the Economy
When the Federal Reserve (the Fed) changes interest rates, it has a ripple effect throughout the broader economy, affecting the stock and bond markets in different ways. Lowering rates makes borrowing money cheaper, which encourages consumer and business spending and investment and can boost asset prices. Problems associated with lower rates include inflation and liquidity traps, which undermine the effectiveness of low rates.
Higher interest rates, on the other hand, discourage people from borrowing money because it costs them more. This leads to people purchasing fewer goods, resulting in less demand. This, in turn, slows down business growth, share prices, and the economy as a whole.
After more than a decade of an historically low interest rate environment, the US economy is experiencing significant shifts due to higher interest rates implemented by the Federal Reserve in 2022 and 2023. The rate hikes, aimed at curbing inflation, led to a decrease in household borrowing and spending, slowing down economic growth. Like a double-edged sword, these higher rates also increased borrowing costs for businesses, potentially impacting future growth, future hiring, and weighing on company stock performance. Despite these challenges, the economy continues to remain resilient.
Looking ahead, the Federal Reserve has projected that rates would remain elevated through 2024.f The economy has, so far, been strong enough to handle higher rates. However, we are skeptical about the economy’s ability to continue to remain healthy if rates remain higher for an extended period.
The Effect on Markets? It’s Complicated
In very simple terms, higher interest rates have historically tended to negatively affect earnings and stock prices. In the real world, the relationship between interest rates and stock market performance is complex and influenced by a variety of factors. For instance, persistently elevated interest rates may change the outlook for stocks carrying valuation premiums. Moreover, historical data shows that during the five most recent long-term periods of rate hikes, the three leading stock market indexes only declined during one rate hike cycle. Again, it’s complicated.
One example of this intricacy can be seen in the financial sector, specifically banks. One of the ways banks make money is by accepting cash deposits from their customers in return for interest payments and then investing that money elsewhere. Rising interest rates give banks the opportunity to earn a higher yield on every dollar they invest through a wider spread between the rate the pay to depositors and the rate they receive on their investments. But that’s not always the case. In the right scenario spreads can tighten, causing lower yields on every investment dollar. Factor in the other business lines a bank can have – lending, credit cards, wealth management – and suddenly the simple isn’t so simple.
But here’s where we think it gets interesting: US-based publicly traded companies have demonstrated the ability to protect their profit margins through various strategies. One of the key strategies is passing on rising supply chain costs to consumers. Another tactic is adjusting their business models and operations to the changing economic landscape. So even in the face of rising inflation, major U.S. corporations have been able to increase profitability and increased earnings for the S&P500 index.
Chart #1: https://fred.stlouisfed.org/series/CP# Data 01/01/18 – 04/01/23 as of 10/02/23. An index is not managed and not available for direct investment. Past performance is not a guarantee of future results.
Chart #2: https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/ Source: Compustat, Standard & Poor’s, JP Morgan Asset Management. Historical EPS levels are based on annual operating earnings per share. 2023 earnings estimates are based on estimates from Standard & Poor’s and FactSet Market Aggregates. Percentages may not sum due to rounding. Past performance is not indicative of future returns. Data as of 09/30/2023
Sometimes the simple and obvious isn’t right.
The simple story that we believe short-term interest rates moving from essentially zero to above 5% in less than 18 months will wreak havoc on the economy hasn’t worked out. Quarter after quarter many economists have been calling for an economic recession that hasn’t happened. Instead, the consumer has continued to spend and earnings have continued to increase.
The current higher interest rate environment has been considered by many analysts to be bad for the stock market. Over the last few months this has been absolutely true. But in our experience, more companies than not adapt. Strong management teams will act to make the necessary changes to their business model and capital structure to move past the short-term stress caused by higher rates. Those companies that can’t or won’t adapt may struggle, get bought, or file for bankruptcy.
Monetary policy decisions from the Federal Reserve play a part in this, but so does the adaptability of Corporate America and the resilience of the American consumer.
In the long run, earnings are what drive the market. Looking ahead the earnings forecast appears solid (Chart #2). And while the stock market can act rather irrationally at times, we see higher earnings as a formula for future gains for the market indexes.
Our advice: remember your investment timeframe, remain calm, and stick with your investment plan.
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Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.All investing involves risks including the possible loss of principal invested. Past performance is not a guarantee of future results.
Index returns are not fund returns. An index is unmanaged and not available for investment.
Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of 30 “blue-chip” industrial U.S. stocks.
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
S&P Midcap 400 Index: The S&P Midcap 400 Index is a capitalization-weighted index measuring the performance of the mid-range sector of the U.S. stock market, and represents approximately 7% of the total market value of U.S. equities. Companies in the Index fall between the S&P 500 Index and the S&P SmallCap 600 Index in size: between $1-4 billion.
S&P Small-Cap 600 Index: The S&P SmallCap 600 Index consists of 600 domestic stocks chosen for market size, liquidity (bid-asked spread, ownership, share turnover and number of no trade days) and industry group representation. It is a market value-weighted index (stock price times the number of shares outstanding), with each stock’s weight in the index proportionate to its market value.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
MSCI World Index: The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance.
MSCI EAFE® Index: The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
The CRB (Commodity Research Bureau) Index measures the overall direction of commodity sectors. The CRB was designed to isolate and reveal the directional movement of prices in overall commodities trades.
Bloomberg Barclays U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
NASDAQ Composite Index: The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market.
Russell 2000® Index: The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents.
U.S. Dollar Index (USDX) measures the value of the U.S. dollar relative to majority of its most significant trading partners. The index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies.
Technical analysis is only one form of analysis. Investors should also consider the merits of Fundamental and Quantitative analysis when making investment decision. Technical analysis is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the bond’s price. Credit risk is the risk that the issuer will default on payments of interest and/or principal. The risk is heightened in lower rate bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Investing in commodities is not suitable for all investors. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The prices of various commodities may fluctuate based on numerous factors including changes in supply and demand relationships, weather and acts of nature, agricultural conditions, international trade conditions, fiscal monetary and exchange control programs, domestic and foreign political and economic events and policies, and changes in interest rates or sectors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks, including futures roll yield risk.