Weekly Investment Update (10/06/2023)

This Week’s Views and Positioning

This week, the results of both the jobs report and manufacturing data supported our view that a severe recession is unlikely. This is important from a broad risk perspective, as the largest equity market declines most often coincide with significant economic contractions. For context, bear markets that occur during recessions have an average decline of nearly 40% versus 26% for non-recessionary bear markets.

Although the jobs report was certainly much stronger than expected, investors are cheering the average hourly earnings data, which came in below forecasts: a 0.2% month-over-month increase versus expectations for 0.3%. A strong labor market with evidence of slowing wage gains is encouraging. Further, the household survey was softer, perhaps offsetting some of the unequivocal strength in the nonfarm payroll numbers. Overall, though, we would not read too much into one report, and we do not expect the Fed will either.

Although bond market expectations for a rate hike in November increased modestly after the report, we do not believe this recent data materially changes the Fed’s likely policy path. Our base case is that the Fed is done with rate hikes, and additional evidence of slowing economic growth should support that view in the fourth quarter. Investors will likely welcome further confirmation of a Fed pause, supporting our overweight to equities.

Higher Treasury Yields Driving Volatility in Equity Markets

What happened: Bond yields have risen sharply in recent weeks with the 10-year yield reaching near 4.8% and the 30-year yield briefly topping 5.0% this week, the highest levels since August 2007. With yield curves steepening dramatically and real yields also rising (the 10-year real yield hit 2.5%, a post-GFC high), risk assets swooned, and the S&P 500 hit a four-month low before strengthening into the end of the week.

Likely drivers of the yield move include investor expectations for improved U.S. growth in addition to concerns about the market’s ability to absorb a large amount of debt amid growing federal deficits. Several data releases indicated the economy is proving to be remarkably resilient; in addition to a surprise 7.7% increase in August job openings and a strong September payrolls report, September’s ISM manufacturing of 49.0 was above the 47.6 expected with new orders of 49.2 reaching a 13-month high.

As the rise in bond yields increasingly diverged from improving growth expectations, investors looked for additional reasons for the yield move. Additional factors behind the moves also included technical and positioning dynamics as well as the impact of voluminous U.S. deficits on the bond market given the rising term premium, or extra yield that investors are demanding in order to lock up their money for longer periods. A sustained rise in Treasury yields increases the debt burden for the U.S. government given the higher borrowing costs associated with the Treasury issuance. Finally, decreased foreign demand has also been credited for the yield move with China stepping away from being a key marginal buyer of Treasuries and Japan looking to sell Treasuries to buy yen.

Why it matters: Higher borrowing costs, if sustained, have the potential to weigh on investment and hiring activity, thus slowing economic growth through next year. Cooling inflation and slowing growth combined with central bank policy rates peaking will eventually work in combination to place downward pressure on yields. However, to the extent Treasury yields are being driven primarily by imbalances in supply and demand given elevated deficits and quantitative tightening, rate downside from slower growth may be limited.

We believe the need for additional Fed hikes has diminished as lagged effects of previous interest rate rises are still feeding through to the economy. Additionally, the risk of spillover effects from tighter financial conditions has risen given the speed of the yield move, and higher yields are likely doing some of the monetary tightening work for the Fed. San Francisco Fed President Daly equated the recent yield increase to one Fed rate hike, indicating the Fed hiking cycle could be complete. Expectations are split regarding whether the Fed holds rates at current levels through next year. The market is now pricing a roughly 50% probability of another 25 bp increase this year and a year-end federal funds rate of 4.65%, implying investors now expect fewer cuts next year relative to several months ago. In our view, further evidence of slower growth should place downward pressure on yields into next year. As a result, bond portfolios are positioned with longer-than-benchmark duration.

While the borrowing trends of the U.S. government amid mixed demand for Treasuries are concerning from a longer-term perspective, we do not think the recent pick up in yields is a sign of impending doom due to this factor. We note that the U.S. dollar has continued strengthening and gold is declining, moves that are at odds with the idea that there is significant concern about U.S. financing. Additionally, over long periods of time, rising deficits and yield levels do not have a strong correlation. We are continuing to closely monitor this development in terms of both the shorter and longer-term outlook, but believe it is important to keep it in perspective alongside other factors that are driving the economy and markets.

Labor Market Remains Strong, Signs of Future Softening Persist

What happened: Nonfarm payrolls surprised to the upside, doubling economists’ estimates of 170K new jobs by adding 336K jobs in September. Strong job gains were mostly driven by the leisure and hospitality, government, and healthcare sectors. The strength in September was paired with 119K of upward revisions in job growth over the prior two months, a sharp rise in job openings this week, and still-low initial jobless claims. However, job growth in the household survey used to measure the unemployment rate was modest with an 86K increase in new workers finding employment, leaving the unemployment rate unchanged at 3.8%. The ADP employment report also painted a softer picture of job growth with figures coming in below expectations, echoing the weakness seen in the household report. Notably, wage growth did soften, a development the Federal Reserve will welcome.

Why it matters: Given the strength of the headline number, one might have expected a meaningful move lower in stocks. This has been the recent pattern as strong economic data has increased the fear of higher interest rates. While this report will have the Federal Reserve focused on the upside risks to growth and inflation, investors took comfort in additional evidence that wage growth is slowing, as rising wages would be a more direct transmission mechanism to inflation. Monetary policy impacts the economy with a lag, and while this report was stronger than expected, we do expect to see a softening in the labor market going forward. Key indicators that lead unemployment, such as temporary help and small business hiring intentions, continue to weaken, pointing to slower job growth ahead. Thus far, the Fed has been able to slow wage growth without materially weakening the labor market, an encouraging combination for risk assets.