Key themes for the Q4

September was a torrid month for risk assets, which should come as no surprise as historically September is the worst month for stocks. The S&P 500 was down more than 5.4% last month, which is the biggest monthly sell off since December 2022. Added to that, this is the first quarterly drawdown for the S&P 500 in a year. The 10-year US Treasury yield – considered the global benchmark - rose 38 basis points on the month, the 30-year US yield rose by a similar amount. The US Treasury yield curve has bear steepened to the tune of 64 basis points in Q3, which means that the cost of money has risen in the US, but also around the world due to the importance of US Treasuries. Added to this, the volatility in the bond market has triggered risk aversion, as the sharp rise in the 10-year Treasury yield highlights how US government debt is no longer a risk-free asset. As we move into the fourth quarter, some key themes are emerging: 1, bond market sell offs, 2, data- watching and 3, optimistic analyst outlooks for stocks. Below, we will give our take.

1, The bond market sells off

This is one of the most important themes due to the central position of bond markets, and the US Treasury market, in global finance. The sell-off in bonds was triggered by a few factors: 1, better economic data that has given rise to the narrative about the US economy having a soft landing and higher for longer interest rates. 2, The debt wrangling in Washington that led to the US being, once again, on the cusp of a government shut down and a potential default. This has happened before, however, the lack of a long-term resolution is starting to impact market sentiment and is a constant reminder of how large the US fiscal deficit is, and how much borrowing is taking place by the government. While other governments’, such as the UK, is scaling back spending after splashing out during Covid, the US continues to spend with the Inflation Reduction Act, and this is impacting the US bond market.  The question of how the US deficit, and other deficits around the world including Italy, will be financed is starting to influence bond market dynamics, with bond investors now demanding more reward for holding government debt, some of which was previously considered a risk-free asset.

Bond yields have continued to rise on Monday, even after the US announced a stop gap funding bill to avert the US government’s fourth shutdown in a decade. However, the markets know that the can has merely been kicked down the road, and that another wrangle will come up in late November. The risk is that political infighting continues, as we lead up to next year’s Presidential election, which makes a sustainable solution to the debt ceiling difficult to achieve.

When politics interfere with financial markets, and interest rates have risen at one of their fastest paces in decades, it is no wonder that the bond market is skittish, and a re-pricing of risk is to be expected. If bond yields continue to rise throughout October and Q4, then the Fed may need to step in with more quantitative easing to bring down Treasury yields, at the same time as the Fed has been embarking on a programme of quantitative tightening. There have been many people predicting that the Fed will continue to tighten interest rates until it breaks something, but what if it’s already broken the Treasury market?

2, Data Watching

Central banks including the Federal Reserve, the Bank of England and the European Central Bank have all ditched forward guidance in favour of a data-led approach to deciding on policy. This was exemplified by the BOE, they held rates steady in September after a lower-than-expected August inflation reading. This pause in rates was passed by a slim margin, but the markets only expected the BOE to pause after the release of the inflation report, a week before the BOE meeting. Thus, central bankers’ wait and see approach is also stoking volatility in the bond market and the interest rate futures market, which is impacting sentiment towards risky assets. For example, trading in options tied to the Vix volatility index is on track to hit a record volume in 2023, as investors try to protect themselves from rapid reversals in stock markets.

So, what is the data telling us? Last week we saw lower than expected core PCE for the US, with the annual core CPE rate for August dropping to 3.9% from 4.3%. However, personal income was higher, rising by 0.4% in August, compared to 0.2% in July. While the decline in core CPE is welcome, the rise in personal income highlights how the Fed cannot take their eye off the ball, as rising incomes could lead to inflation pressure down the road. Looking ahead to this week, the market will be fixated with US NFPs on Friday along with average wage data for the US. Global PMIs are worth watching, to see if European PMIs recover slightly and if the US’s ISM service sector survey pulls back from the jump in the August figure. It’s also worth noting that compared to Europe, the US service sector ISM has not been in contractionary territory since December 2022. If a recession is coming for the US, we would expect to see it here first.

The US data is also important for the US dollar, which rose more than 3.2% on a broad basis last month. USD/JPY was in the firing line, and was down nearly 3% in September. This pair is now edging towards 150.00, which appears inevitable, however, the sharp decline in the yen could trigger official intervention from the Japanese authorities, so if we see a rapid rise in USD/JPY above 150.00, then things could get volatile for this pair.

The pound was one of the weakest G10 currencies last month after the BOE halted rate increases, and the UK did not see the big sell off in its bond prices, the 10-year UK Gilt yield only rose 10 basis points last month, partly because UK yields are already elevated and partly because inflation has fallen faster than expected. A weak payrolls number this week looks like it might be the only thing that stops GBP/USD from getting too comfortable below $1.20, as a breach of this level now looks inevitable after this pair fell 1% last week and is lower by 0.9% on Monday.

3, Q4 stock market outlook

Stocks are up a touch on Monday, even though the US 10-Year yield rose by another 10 basis points.  After the 2.7% decline in the S&P 500 last month, industry analysts expect the S&P 500 to rise by 19% in the next 12 months, according to data provider FactSet. Tech, consumer discretionary and real estate are predicted to lead the rally, all sectors that have had a torrid time of it in recent months.  In contrast, the energy sector is expected to see the smallest upside, although analysts currently have the highest number of buy ratings for the energy sector. If you trust analyst views then there could be big change ahead for stock markets and after the recent sell off, we could be close to a nadir for global stocks. As mentioned above, we don’t think that the selloff will stop until the bond market volatility calms down. So, if you want to know what will happen with stocks, watch bonds.