Asset Allocation Strategy
6 November 2023
Correction Pressures Easing
A Year of Two Phases

So far, 2023 is proving to be a year of 2 phases for global equity markets. Despite the bout of bank turmoil which weighed on equities in the first quarter, stocks rallied for the most part of the first 7 months of the year. 

So far, 2023 is proving to be a year of 2 phases for global equity markets. Despite the bout of bank turmoil which weighed on equities in Q1, stocks rallied for the most part of the first 7 months of the year. 

This rally has since morphed into a general selloff with global stocks on an overall downtrend for the past 3 months. 

The S&P 500 fell more than 10% from its 2023 peak on the final day of July (though it has since recovered to a 7.5% drawdown), meeting the popular definition of a market “correction”. This recent retracement is the second since last year’s October lows, following the -8% regional bank correction of February/March. These corrections have occurred within what has been a very strong global equity up-trend over the past year (+19%). 

Figure 1: The US market has experienced 4 corrections of 10% in the past 2 years
Figure 2: It is worth noting that 10% corrections are quite normal and to be expected, occurring roughly every year and a half
S&P500 Intra-year decline Average occurrence per year
-5% 1.1 years
-10% 1.5 years
-20% 4 years
-30% 9 years

Data since 1980. Source: Refinitiv, Wilsons Advisory.

Rising Bond Yields Drag Equities into Correction Mode

The key factor driving the correction appears to have been the US bond market, with the surge in the 10-year treasury yield through 4% in late July and toward 5% in October coinciding with the correction in equities. 

It is therefore no surprise that bond yields have been central to the rebound in equities over the last week. The Fed left rates on hold last week, and marginally more dovish comments from Fed Chairman Powell buoyed hopes that the Fed is finished raising rates. US 10-year yields have eased 25 basis points (bps) this past week to 4.67%, while equities have risen 4.8% from their lows.

Figure 3: 10-year treasury yields surged to a 16-year high in October

Unexpectedly resilient economic data (including a strong third quarter GDP print), the market’s adjustment to the Fed’s “higher-for-longer” narrative on interest rates, and the Israel-Hamas conflict, which began on October 7, contributed to the outsized moves in bond yields. 

Equities proved overly sensitive to the increase in rate volatility through October, as the 10-year treasury yield rose by roughly 2 standard deviations. In just 1 week, the rate on the 10-year swung in a range of almost 40 bps, buffeted by crosscurrents including resilient retail sales and jobless figures, mixed messages from Fed officials and rising demand for safe haven assets amid concerns of an escalating conflict in the Middle East. Signs of escalation prompted a reactionary bid for safety, causing 10-year yields to retrench with moves in the order of ~10 bps. 

The MOVE index (the bond market’s VIX equivalent), which tracks anticipated swings in treasury yields priced into 1-month options of treasury yields, climbed for 5 straight weeks to the end of October. This suggests considerable uncertainty around the path of bond yields.

Figure 4: The MOVE index (bond market volatility) suggests considerable uncertainty around the path of bond yields

Concerns over the US’s fiscal future are also increasingly affecting investor sentiment. The move in yields was also exacerbated by the prospect of a deluge of bond supply – the US budget deficit is running at 8% of GDP, while the costs of servicing existing debt are already up to 15% of tax revenues. Growing US debt issuance has lifted the term premium by more than 1 percentage point over the past 3 months. 

The retracement has been relatively broad based across market sectors, the Energy sector being the exception. That said, the rebound from the October 2022 low to the recent peak in July was pretty spectacular, with average S&P 500 sector performance of 22% and 16% across the ASX200 sectors. The last two trading days have seen a material rally in equities: in the Thursday session alone, all S&P 500 sectors closed higher by more than 1%.

Figure 5: Sector performance
Energy Info Tech Healthcare Financials Industrials Materials Utilities Comm. Services Consumer Disc. Consumer Stap. Real Estate
S&P500 Sector Performance
October 2022 low to July 2023 peak 8.6% 55.1% 9.9% 16.8% 30.2% 25.1% 9.0% 43.3% 24.3% 12.7% 12.3%
July 2023 to recent low -3.0% -9.9% -8.2% -11.0% -12.7% -12.5% -12.4% -7.7% -13.1% -11.4% -15.3%
ASX200 Sector Performance
October 2022 low to July 2023 peak 8.8% 37.7% 1.5% 6.7% 16.9% 16.5% 37.9% 17.0% 13.3% 7.7% 13.9%
July 2023 to recent low -3.5% -16.5% -14.1% -6.4% -12.0% -5.5% -4.6% -8.7% -4.2% -9.6% -12.9%

Source: Refinitiv, Wilsons Advisory.

Figure 6: US economic data has surprised consensus to the upside so far this year; the second wave of positive data surprises has driven yields higher

Hot Data

Starting with economic growth, it is clear that the economy was much stronger in the third quarter than many had feared earlier in the year. While this economic resilience has been a supportive factor for global equity performance for much of the year, it has recently prompted both the Fed and the market to reassess expectations for US interest rates, driving up bond yields to fresh cyclical highs (see figure 6).

Real GDP grew at a 4.9% annualized rate, above the already lofty market expectation of 3.8% growth. This quarter represented the strongest in nearly 2 years, with consumers very much in the driver’s seat. While government spending, private inventory investment and residential fixed investment were all contributors, consumption contributed 2.7 percentage points to the overall increase. Buoyed by persistently strong labor income, consumers continue to defy expectations for a slowdown.

That said, it is important to note that GDP is a backward set of data. While the report certainly lends support to the “soft landing” narrative - perhaps even to a “no landing” one - there were some trends below the surface that bear watching. 

Interestingly, while consumption was no doubt encouraged by nearly full employment, some of the consumer demand was sated by savings, as the personal savings rate fell from 5.2% to 3.8%. The worry here is that the below-normal savings rate signals a consumer that is spending more aggressively than can be sustained. With the resumption of student loan repayments, along with tighter credit and higher borrowing costs, we can anticipate consumption to slow. Avoiding a recession remains our base case for the US economy, but we are watching the trends across the US consumer closely. Any significant cracks in the labour market could hit the consumer quickly, with confidence already under some downward pressure.

All in all, economic growth has held up much better than expected in the face of higher rates. It is our sense, however, that the acceleration represents a last hurrah rather than a second wind. Certainly, it will be a historical anomaly if the Fed raises interest rates by over 5% in record time and the economy responds with a sustained acceleration.


Tightening Conditions Doing Some of the Heavy Lifting

As noted by a number of Federal Reserve governors over the past few weeks, the strong rise in long-term interest rates have in effect been helping do the bank's job of tightening credit conditions, putting additional downward pressure on the economy and, hence, on prices as well. 

Figure 7: The tightening in the US Financial conditions index since August has been equivalent to about 75bps of Fed rate hikes

On the inflation front, impressive progress has been made. The Fed’s preferred measure of inflation - Core personal consumption measures (PCE) - moved down to 3.7% in September, the lowest level since May 2021. The Fed Funds rate is now 1.6% above core PCE, the most restrictive monetary policy we have seen since 2007.

The takeaway from last week’s Federal Open Market Committee (FOMC) meeting is that as long as the disinflationary trend is intact and economic growth moderates in the fourth quarter, the Fed is likely to keep policy on hold over the coming months. Already, inflation is trending below the Fed's median year-end forecast, and the Atlanta Fed's GDPNow model shows the fourth quarter growth tracking 1.2%.

Figure 8: On this measure, the Fed Funds rate is the most restrictive monetary policy since 2007

Balanced Against all of this, However, are Increasingly Attractive Valuations and, So Far, Decent Earnings.

The forward price-to-earnings (PE) ratio on the S&P 500 has fallen just below its 10-year average and, outside of the top 10 stocks, is close to a 20-year average multiple.

With large US companies in the midst of third-quarter earnings season, a few high-profile disappointments have added to the negative mood among investors, despite the fact profits overall have been resilient. 

Google parent Alphabet dropped almost 10% last week after narrowly missing revenue forecasts in 1 division, whereas companies that beat expectations,
such as Microsoft, enjoyed only modest share price gains. The artificial intelligence (AI) driven rally, which propelled PE multiples (particularly for tech and tech-adjacent stocks) to well above historical averages in July, had once again raised the question of whether the US market was overvalued. This backdrop could help explain why companies that miss earnings expectations are being punished with unusual harshness. 

We see current analyst expectations for 11.9% US earnings growth in CY24 as too high, although this estimate has edged lower since September (12.2%). What really matters for equity performance apart from interest rates are years when earnings growth turns sharply negative. At this stage, the risk of a recessionary, double-digit decline in earnings appears reasonably low in our view. Flat to low single digit earnings growth is our central case view, combined with lower bond yields. This is likely to prove a reasonable backdrop for equities, in our view.

Figure 9: US stocks looking fair value, back below the 10-year average PE
Figure 10: Forward earnings expectations have been pared back slightly

Return of the Bears

The recent correction has seen individual investors become increasingly bearish (which is bullish from a contrarian perspective). This fits the historical pattern of individual investor sentiment nearly perfectly following the market trajectory, becoming bullish as markets reach new highs, and trending bearish as prices fall. Between the end of July and the end of last week, the spread flipped, declining from 30% (net bullish) to minus 13% (net bearish). 

Figure 11: The spread between AAII bulls vs bears has faded quickly from peak optimism in July

Stay the Course

While rates volatility may well persist in the near term, our base case is for the sharp rise in bond yields seen over the past few months to reverse course as it becomes clear that the Fed funds has peaked, as signs of a growth slowdown accumulate over coming months. Although it is early days, the equity market’s reaction to the drop in yields in the last few trading sessions is noteworthy.

When analysing consumer dynamics, it is hard to escape the conclusion that the US consumer is set to slow significantly over the coming year, as excess savings are exhausted and other headwinds (e.g. resumption of student loans repayments and higher interest costs) present themselves. So, we expect US growth to slow (but not collapse) over coming quarters, inflation should also continue easing over the coming 12 months.This should be a reasonably supportive backdrop for both stocks and bonds, all things equal. 

Improved valuations in both bonds and equities have opened up enhanced opportunities for those willing to weather short-term volatility. Ultimately the rise in bond yields seen in recent months should weigh on the growth outlook alongside the Feds own policy tightening. Moderating inflation and employment will remain key data signposts for sentiment and thus market direction over coming months.

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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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