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Market Commentary: How Bad Is It?

Stocks fell again last week, even as yields paused and overall earnings were solid. As of Thursday, the S&P 500 is down nearly 10% from its late-July peak. A decline of 10% or more would be classified as a correction. It’s important to know that 10% corrections occur most years. Since 1980, 22 out of 42 years saw at least one double-digit, peak-to-trough correction, with 12 of those years ending higher and gaining an average of 17.0%.

  • Stocks continue to struggle, but that is not abnormal for this time of year.
  • Odds still favor a major low soon, and a year-end rally remains likely.
  • While economic growth may have peaked in the third quarter, we expect the economy to remain supportive.
  • Consumer services and government spending are likely to remain strong contributors to growth in the final quarter of the year.

The market’s weakness over the past three months has not been fun for investors. But after the S&P 500 had its best seven months since 1997, some type of seasonal weakness was expected. The good news is a bear market or continued weakness is not inevitable.

October has been weaker than we expected, but this month is often particularly weak in pre-election years. Stocks also tend to find a major low in late October. In fact, the average year since 1950 saw stocks bottom around Oct. 27 before a year-end rally. With the economy on firm footing and sentiment turning pessimistic, we remain optimistic a significant year-end rally is still possible.

The Energizer Bunny Economy

You just can’t put this economy down. There are expectations and then there’s reality. Earlier this year, expectations were for a mild recession in the second half of 2023. That was then revised to a more optimistic outlook as time went by (and data came through). On the eve of the third quarter GDP release, expectations for growth had risen as high as 3.8%. The actual reading blew past those expectations, with the economy growing 4.9% in the third quarter, after adjusting for inflation.

Consider this: Real GDP growth has grown faster than what the Congressional Budget Office projected just before the pandemic in January 2020. It also projected the unemployment rate in 2023 would be 4.4%. It’s 3.8% now.

It’s important to maintain perspective, because the economy has grown more than expected (in real terms) in the face of three massive shocks:

  • A worldwide pandemic that killed millions of people, resulting in massive job losses and businesses going under.
  • An energy price shock that sent inflation to its highest level in 40 years. Historically, energy shocks have pushed the U.S. into a recession, but not this time.
  • The most aggressive Federal Reserve tightening cycle since the early 1980s. Surging interest rates crushed the housing market in 2022, which was not unexpected. Historically, housing downturns have preceded recessions, but not this time.

Keep in mind the trajectory of economic growth was not a given, considering the scale of the shocks. In fact, COVID-19 and its aftermath economically scarred most other developed market economies, which experienced significant output loss relative to pre-pandemic expectations. The U.S. is the odd one out, as its output is running above pre-pandemic expectations.

The inflation trajectory in the U.S. is also relatively positive. Despite the U.S. government pushing more fiscal stimulus into the economy, inflation in the U.S. is now running below many other developed economies. The chart below shows core inflation — excluding food, energy, and owners’ equivalent rent — enabling cross-country comparisons.

What Comes Next for the Economy

A significant reason for GDP growth coming in close to 5% in the third quarter was businesses rebuilt their inventories. That added 1.3 percentage points to the headline number. But inventories (along with net exports) can be volatile from quarter to quarter. It helps to extend the horizon. Incredibly, the economy has grown faster than the 2017-2019 pace of 2.8%. Over the last year, it’s grown 2.9%, and over the last two quarters it’s grown 3.5% (all in real terms). That illustrates the current underlying speed of the economy.

Two major sectors, which make up just more than 60% of the economy, are powering this momentum:

  • Services consumption (45% of the economy) is running ahead of its pre-pandemic pace.
  • Government spending (17% of the economy) is also running strong on the back of federal government nondefense and defense spending and investment, as well as state and local government spending.

More recently, housing has gone from being a massive drag on the economy to a slightly positive contributor. Residential investment contributed to GDP growth in the third quarter for the first time in 10 quarters. Incredibly, that’s come in the face of mortgage rates north of 8%. What’s happening is that high mortgage rates are locking many homeowners in their homes, so inventory of existing homes is low. That’s pushing potential homebuyers into the new homes market, boosting single-family housing construction. In any case, this dynamic is likely to continue and even if housing doesn’t contribute much to GDP going forward, it’s unlikely to impede the economy as much as it did in 2022.

Outlook for the Big Two: Services Spending and Government Spending

Stronger spending is a direct result of higher incomes across all workers in the economy. Overall income growth is running around 5%, thanks to robust employment gains, strong hourly wage growth, and hours worked at similar levels to pre-pandemic months. Plus, as I pointed out in a prior blog, household balance sheets are in good shape. Median net worth rose 37% between 2019 and 2022. So, households feel less urgency to save and solidify their balance sheets, unlike what happened after the stock market and housing crash in 2008. Yet another tailwind: Gas prices are falling. Nationwide average gas prices have fallen from about $3.90 a gallon to $3.50. Food inflation is also easing. That will boost household wallets.

With respect to government spending, it’s unlikely more money for nondefense will be authorized by Congress given the political makeup. However, there’s plenty left in the tank within the Bipartisan Infrastructure Deal, CHIPS Act, and the Inflation Reduction Act — only a fraction of the spending authority given by Congress has been exercised to date. There’s more to come.

Defense spending rose at an annualized pace of 8% in the third quarter, the fastest pace since the fourth quarter of 2020. Defense spending is currently just 3.6% of GDP, which is close to an all-time low. It’s likely this moves higher going forward.

State and local government spending makes up 11% of the economy, which is significant. Governments cut back significantly between 2020 and 2022, in preparation for a storm. But they’re starting to ramp up spending and investment, and this is likely to continue over the next few quarters. Sales taxes and property taxes should remain strong if spending is resilient, which is likely if the economy avoids a recession as we expect, and a housing market crash is averted, which is also likely given demand dynamics. This runs in sharp contrast to the global financial crisis, after which states struggled and cut back on spending for several years.

What Does This Mean for the Fed?

This data matters to the Fed for two key reasons:

  • Economic strength solidifies the idea of higher for longer. That’s likely to continue until the data softens, which should happen soon as the third quarter’s torrid pace of growth is unlikely to continue.
  • Slower inflation will probably stay the Fed’s hand from raising rates further. Core inflation, as measured by the personal consumption expenditures index, clocked in at 2.4% in the third quarter. That was softer than expected and the slowest pace since the end of 2020.

Equity markets appear to be struggling to come to terms with the idea of elevated interest rates. But ultimately, higher rates are mostly reflecting a stronger economy, and that’s good news for profits. Carson’s Ryan Detrick recently wrote about how forward estimates of profits and profit margins are rising. While we’re currently experiencing a “good news is bad news” dynamic, that’s likely to shift eventually.

The economy may have peaked for the near term in the third quarter, but many forces that have contributed to growth in the last year are still in play. Some mean reversion in fourth quarter growth around inventories could occur, but the main drivers of growth from the third quarter (government and consumer spending) are likely to remain solid. That economic backdrop, together with seasonal factors, improves the odds that an equity rally will gain traction soon.