The Weekly Five

Tiptoeing Out of September

Sept. 29, 2023

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

Encouraging inflation data was a welcome bright spot in a week that feels fraught with uncertainty as lawmakers are on track to miss the deadline to pass a 2024 federal budget. Meanwhile, housing markets — central to the economy and U.S. consumers’ budgets — are feeling the strain of higher interest rates and we have difficulty seeing equity valuations or treasury yields as sustainable. Here are five thoughts on this week’s events:

Something’s got to give in housing – what will it be?

The U.S. housing market continues to feel the strain of drastically higher financing rates. Pending home sales fell 7.1% month-over-month in August to an 18.8% decline year-over-year. Thirty-year fixed mortgage rates topped 7.6% this week, a 23-year high. Elevated rates have created a bit of a standoff, with buyers feeling the pressure of financing coupled with low inventory and sellers who are reluctant to part with their own lower existing mortgage rates.

Housing prices remain elevated as a result, exacerbating the overall pressure in a higher-for-longer environment. It seems likely that home prices may begin to feel downward pressure. For context, home values would need to decline by about 30% to match the monthly mortgage payment a home buyer would have paid in the pre-pandemic interest rate environment, where 30-year fixed-rate mortgages were at 3%.

How worrisome were the latest inflation data?

The trend is our friend. U.S. inflation continues to move in the right direction, with the August personal consumption expenditure price index rising 0.4% month-over-month, slightly better than expected and lifting the year-over-year increase to 3.5%. The core PCE, the Federal Reserve’s preferred measure, rose 0.1% from the previous month to an annual pace of 3.9%, meeting economists’ expectations.

The good news, however, is the decelerating pace of core inflation, with a six-month annualized rate of 3%, and the three-month annualized pace of 2.7%. All of this improvement, of course, is happening concurrent with a strong labor market and resilient economy. Our view remains that while too early to declare victory, this will be interpreted as good news by the Fed. We continue to believe that the Fed is at or near the peak policy rate.

What are the building blocks of recent interest-rate volatility?

While ending the week on a softer note, U.S. interest rates continued to rise through the month of September. The two-year Treasury yield, the most sensitive to monetary policy conditions, has risen above 5% from 4.87%. The 10-year Treasury yield has topped 4.5% from 4.18% just at the beginning of the month.

There are likely three driving forces behind these moves. One: The market has embraced the “higher for longer” monetary policy stance. Two: Investors have reset expectations for the economy to anticipate a soft economic landing, taking the recession forecast off the table. And three: Much of the move may be a simple case of supply and demand, as the U.S. Treasury has increased issuance across the maturity spectrum, forecasting that “gradual increases will likely be necessary in future quarters.” This all but confirms market expectations of larger auctions to come. At the same time, the Fed continues to reduce the size of its balance sheet by $60 billion a month. Our view is that interest rates have probably moved too far, too fast, with a 10-year treasury yield above our six-month forecast. We continue to advise investors to consider taking advantage of higher interest rates to potentially de-risk the funding of high-priority goals.

Will mega-cap stocks continue to buoy U.S. equities?

Although it continues to be a bumpy season for stocks, mega-cap U.S. equities continue to outperform. This is despite the conventional wisdom that these highly valued stocks from a price-to-earnings perspective are particularly vulnerable to interest rate increases. That simply has not been the case this year. Mega-cap growth has continued to chug along despite the dramatic increase in interest rates.

Investors continue to favor tech and tech-adjacent companies, particularly those with exposure to artificial intelligence. As we have noted many times before, the overall U.S. equity market as reflected in the Standard & Poor’s 500 Index benchmark remains expensive relative to history. While the recent selloff has taken valuations down slightly from 21.7 times earnings in the middle of the month, we continue to believe that the 2024 earnings estimates remain too high and are vulnerable to downgrade. In our view, this likely caps any meaningful near-term upside for stocks.

Where will investors see the effects of a U.S. government shutdown?

It seems unavoidable that the U.S. government will shut down after Congress fails to pass a 2024 budget by the Oct. 1 deadline. While short-term market impacts to government shutdowns are typically not large, we don’t expect this shutdown to come at no cost to our economy or the government’s credibility to operate effectively. The more subtle and longer-term effects should not be discounted.

A shutdown will delay reporting governmental data that informs market — and perhaps more importantly the Federal Reserve — decisions. This is a particularly consequential issue now, given the uncertainty related to the path of monetary policy, and the heavy data dependence of policy makers. Neel Kashkari, president of the Minneapolis Fed, has suggested that this will be surmountable because the Fed has access to private sector data in the event that government data is unavailable.

Government shutdowns also have a real effect on consumer confidence. Previous shutdowns have generated a drop in the University of Michigan Consumer Sentiment Survey of two to five points compared with the month before the shutdown, or each day the government has been closed has reduced consumer confidence by an average of 0.25 points, according to the nonpartisan Committee for a Responsible Federal Budget. Shutdowns can weigh on consumer spending as the large federal workforce is furloughed, and slow economic growth as government spending is deferred.

What’s more, while previous shutdowns have not triggered a response from ratings companies, Moody’s warned on Sept. 25 that a government shutdown would harm the country’s credit. Moody’s is the last major ratings agency to continue to give U.S. credit its highest AAA rating. Fitch downgraded U.S. government credit to AA+ following the debt ceiling negotiations, and S&P has rated the U.S. AA+ since 2011. The U.S. Treasury has made coupon and principal payments in past shutdowns. Interest on federal debt is not included in the discretionary spending that is at issue in this congressional negotiation. Any downgrade would be an acknowledgement of continued political dysfunction — not concern related to debt service.