Market Commentary

• There are a number of headwinds building that will likely result in a continuation of the slowing economic trend.
• We believe these headwinds will turn the economy, consumer spending, and earnings lower.

The S&P 500 Index (SPX) has had a nice bounce off the late-October lows over the last five weeks. In addition, after hitting 5% in late October, the highest yield in 15 years, the price of the 10-year Treasury note also surged, pushing the yield down to just below 4.2% last week (remember, when bond prices rise, yields generally fall). Price moves in equities and bonds of that magnitude in such a short period of time have happened infrequently. The bottom line is market participants appear to be quite enthusiastic about the potential for a soft economic landing (no recession), a noticeable rise in earnings next year, and a Federal Reserve (Fed) that might cut rates as early as May. We are not optimistic these events will play out the way investors expect.

Our analysis suggests there are a number of headwinds building that will likely result in a continuation of the slowing economic trend, little SPX earnings growth in 2024, and a Fed that keeps rates higher for longer than the market is expecting. Our regular readers have been aware of some, if not all, of these headwinds for much of this year. But as stocks have rallied and yields have fallen, some investors have been questioning whether or not these headwinds will be enough to deter stock prices from a further rise as we move into the early-to-middle portion of next year. Let’s take a look at some headwinds.

Perhaps most importantly for the financial markets, we see investors being ultimately disappointed that the Fed does not start cutting rates as soon as expected. For reference, at the time of this writing, the federal funds futures market is pricing in a slightly more than 50% probability of a rate cut at the March Federal Open Market Committee (FOMC) meeting and nearly a 70% chance of another cut in May. Then, the market is pricing in a minimum 60% chance of a cut at each of the remaining FOMC meetings next year. Expectations for this level of aggressive rates cuts is far too optimistic in our view. Core inflation (which excludes the effects of food and energy) remains well above the Fed’s long-term 2% target. The Fed’s likely path is higher for longer rates until inflation is confidently lower.

We also believe investors are discounting the effects of tightening credit conditions across the economy. Per the Fed’s October quarterly Senior Loan Officer Survey, businesses and consumers are having a tougher time obtaining credit for everything from operating and equipment loans to auto and home loans. The American economy runs on credit. When less credit is available, spending is typically hindered.

While stocks and bonds have staged robust rallies over the last five weeks, we believe these meaningful headwinds will turn the economy, consumer spending, and earnings lower. It does not appear these risks are priced in. We recommend that investors remain defensively positioned.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation, and other risks. Prices tend to be inversely affected by changes in interest rates. Although Treasuries are considered free from credit risk, they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate.

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