Monthly Client Update | November 1, 2023
Stocks & Bonds Trade Lower as Interest Rates Continue to Rise
Monthly Market Summary
- The S&P 500 Index declined -2.2% in October but outperformed the Russell 2000 Index’s -6.9% decline. The Utility sector was the top-performing S&P 500 sector, while Energy and Consumer Discretionary led to the downside.
- Corporate investment-grade bonds produced a -2.4% total return in October, underperforming corporate high-yield bonds’ -1.0% total return.
- International stocks underperformed U.S. stocks. The MSCI EAFE Index of developed market stocks declined -2.9% and slightly outperformed the MSCI Emerging Market Index’s -3.3% return.
Stocks Decline for a Third Month as Rates Reach Highest Levels Since 2007
The S&P 500 gained more than 20% through the end of July but has since declined 8.3% over the past three months, bringing its year-to-date gain to 10.6%. A significant factor behind the recent equity market sell-off has been the sharp rise in interest rates, with the 10-year U.S. Treasury yield climbing +1.25% from mid-July through mid-October and rising above 5% for the first time since 2007. This surge in Treasury yields continues to weigh on both stocks and bonds as valuations adjust to a world of higher interest rates. Small-cap stocks underperformed large-cap stocks by over -4.5% in October, and defensive sectors outperformed cyclical sectors. In the credit market, bonds posted another month of negative returns. The following paragraphs discuss why stocks and bonds tend to experience pressure during rising rate periods.
Why Rising Interest Rates Cause Bonds & Stocks to Trade Lower
Consider two bonds: Bond A was issued one year ago and pays a fixed 2% interest rate, and Bond B was issued one month ago and pays a fixed 2.5% interest rate. On an annual basis, Bond A yields $2 per $100 of principal, while Bond B yields $2.50 per $100 of principal. Assuming all else is equal, a rational investor would choose Bond B because of its higher yield. To attract investors to buy Bond A and align its yield with Bond B’s 2.5% yield, the market will adjust the price of Bond A lower. In our example, the price of Bond A will decline so that its fixed $2 interest payment corresponds to a 2.5% yield. At this adjusted price, investors would earn a 2.5% yield with Bond A, making them indifferent to choosing between Bond A and Bond B.
Rising interest rates also cause stocks to trade lower. As interest rates climb, bonds offer a higher expected return, which makes bonds more competitive with stocks. The higher expected return on bonds can prompt investors to sell stocks and buy bonds, causing stock prices to decline. In addition, higher interest rates increase borrowing costs, which can slow economic growth and reduce corporate profits. If investors expect slower earnings growth, stock prices may decline as investors seek lower valuations to offset the heightened earnings risk.
Monthly Client Update | September 1, 2023
Stocks Trade Lower in August as Interest Rates Rise
Monthly Market Summary
- The S&P 500 Index declined -1.6% in August but outperformed the Russell 2000 Index’s -5.1% decline. Energy was the only S&P 500 sector to trade higher, while Utilities and Consumer Staples led the remaining nine sectors lower.
- Corporate investment-grade bonds produced a -1.2% total return in August, underperforming corporate high-yield bonds’ +0.2% total return.
- International stocks underperformed U.S. stocks in August as the U.S. dollar strengthened. The MSCI EAFE Index of developed market stocks declined -3.9%, outperforming the MSCI Emerging Market Index’s -6.6% return.
Stocks Trade Lower in Early August but Rebound Later in the Month
The S&P 500 traded lower during the first half of August, at one point erasing all of July’s 3.3% gain. The sell-off occurred as investors worried about the potential for further interest rate hikes and increased bond issuance by the Treasury to fund government spending. Interest rates rose to levels last seen in 2007, with the 10-year Treasury yield climbing to 4.35%. This sudden rise in interest rates caught the market by surprise and weighed on stock market valuations. However, interest rates reversed a portion of their rise later in the month, with the 10-year Treasury retreating to 4.09%. The S&P 500 found its footing as yields declined and recovered to finish the month with a -1.6% decline, its first monthly loss since February of this year.
Two data points caused interest rates to decline and contributed to the stock market’s rebound into month-end. First, the number of U.S. job openings fell below 9 million for the first time since March 2021, with separate data showing that fewer employees are voluntarily quitting their jobs. The declines in job openings and quits suggest the tight labor market is improving and may help ease wage inflation. Second, consumer sentiment weakened to a 3-month low in August due to higher borrowing costs and concerns about lingering inflation. Investors interpreted the labor market data and weak consumer sentiment as an indication that the Federal Reserve is making progress in its battle against inflation and may not need to raise interest rates further.
Investors Remain Fixated on the Federal Reserve’s Next Move
The August market action is a continuation of the primary trend we have seen this year. The market remains fixated on the Fed’s next move, including how high the Fed will raise interest rates and whether it will cut interest rates in 2024. Those decisions will significantly impact the economy and stock market, and investors want to position their portfolios correctly. Each economic data point and Fed speech are analyzed for clues about interest rate policy, and as we saw in August, stocks and interest rates can change direction suddenly as new information becomes available. The market outlook has changed multiple times this year due to investors’ short-term focus on Fed policy, but this dynamic is poised to shift as the Fed concludes its rate hike cycle.
Monthly Client Update | August 1, 2023
S&P 500 and Dow Jones Trade Within 5% of Their All-Time Closing Highs
Monthly Market Summary
- The S&P 500 Index gained 3.3% in July but underperformed the Russell 2000 Index’s 6.1% increase. All eleven S&P 500 sectors traded higher, led by the Energy, Communication Service, and Financial sectors.
- Corporate investment grade bonds produced a 0.1% total return in July, underperforming corporate high yield bonds’ 1.1% total return.
- The MSCI EAFE Index of developed market stocks rose by 2.7%, underperforming the MSCI Emerging Market Index’s 6.0% return.
S&P 500 Trades Toward its All-Time Closing High from January 2022
The S&P 500 extended its winning streak to five months in July, bringing its year-to-date total return to 20.5%. The S&P 500 has now recovered most of its losses from 2022 and is currently trading less than 5% below its all-time closing high set in January 2022. On a related note, the Dow Jones Industrial Average, which tracks 30 prominent U.S. companies, recorded a 13-day winning streak in July – its longest since 1987. Like the S&P 500, the Dow Jones is also trading less than 5% below its all-time closing high, set back in January 2022.
What is fueling the stock market’s gains? In one word: expectations. The U.S. economy has defied expectations for a recession, with job growth, consumer spending, and corporate earnings remaining resilient despite higher interest rates. The recent downward trend in inflation data is adding to the optimism, with investors hopeful that the Federal Reserve can achieve a soft landing or potentially avoid a recession altogether. Despite the favorable trends in the first half of 2023, there is concern that the Fed may need to keep raising interest rates due to recent increases in home prices and commodity prices.
Gasoline Prices Rise to a 3-Month High, Prompting Inflation Concerns
Gasoline prices are rising again, sparking concerns among consumers and central bankers alike. According to AAA, the national average price for a gallon of regular gasoline reached a three-month high of $3.75 on July 31st. The recent rise in oil prices is driving this increase, with West Texas Intermediate crude hitting $80 per barrel. Other contributing factors include supply cuts by OPEC and Russia, extreme heat disruptions at refineries that are leading to lower gasoline inventories, and overall optimism about the global economy and demand for oil. While current prices are still below the level of $4.22 per gallon one year ago, the rise in fuel costs could slow the Fed’s progress in curbing inflation and may even require additional interest rate hikes by the central bank. Markets will pay close attention to the energy and overall commodity markets in the upcoming months as the situation unfolds.
