The Stock Market’s Strong Reversal, Interest Rates, and the Middle East

Jeff Buchbinder (00:00):

<Silence> Hello everyone, and welcome to the latest edition of LPL Market Signals. Jeff Buchbinder here, your host for this week with my friend and colleague Lawrence Gillum. How are you today, Lawrence?

Lawrence Gillum  (00:11):

Oh, I'm doing good, Jeff. But it's starting to get cooler here in the Carolinas. It's starting to feel like fall, so it's the best time of the year, in my opinion anyway.

Jeff Buchbinder (00:21):

Yes, well, you need it cooler more than we need it cooler, maybe up here in Boston, but it's, yeah, pleasant 60 degrees and it's not raining for a change, so we'll take that. So it is Monday, October 9, 2023, as we're recording this. It's a bit of a somber day, given what happened over the weekend in Israel. So, we will talk a little bit about that upfront and then get into the regular scheduled program. So, let's start with the disclosures and then the agenda. After we comment on the war in Israel, we'll talk about stocks following the bond market's lead last week, it's really all about rates. Actually, the theme for the whole, really this whole podcast is, is rates. Look at the jobs report from Friday. Interesting market reaction that you know, it certainly looked like it was too strong upfront, but then the market reconsidered, so maybe it wasn't too strong.

Jeff Buchbinder (01:22):

Glad we have Lawrence here with being a fixed income guru, he'll tell us where rates might be going. That's an easy question, easy prediction, right, Lawrence? And then last, we'll preview the week ahead, which is, other than the, you know, focus on what's going on in the Middle East, we will look at earnings season quickly. And talk CPI. So before we get into the recap, just want to comment on the events over the weekend. You know, we've certainly been asked you know, by folks, what might be the potential market impact. I mean, of course, you start with the tragic human cost. It's always uncomfortable to talk about market impact or economic impact at times like these. But that's our job. So that's what we do. So, you know, first you look at the oil market, right?

Jeff Buchbinder (02:16):

That's where this conflict is more likely to be, you know, transmitted into economic weakness. You know, oil's up four or 5%. The energy sector, similarly, and that can of course have impact on economic growth and consumer spending. However, unless Iran is brought into the conflict, the impact on the energy markets might not be very large. You might see this knee-jerk reaction, and then those gains could be short-lived. So certainly, it looks like based on how markets are trading today on Monday, that you know, Iranian involvement is not the base case. So if the conflict remains contained to Israel and Gaza, you might not have much economic impact. You might not even have much energy impact. So that's one piece of this. The other piece is, we'll look back in history when war breaks out, or when you have terrorist attacks, and this is really both.

Jeff Buchbinder (03:22):

You tend to see the stock market shrug it off. You know, if you look back to even World War II, you know, on average, stocks are a little bit higher a month after these events, three months after these events. And really, it's the economic cycle that determines whether stocks fall. So, given where we are in this cycle, we think stocks are more likely to be higher in a month or three months based on history and based on the fact that this economy continues to hold up quite well. So you know, we wouldn't be sellers tactically on this event. And certainly, you know, we are overweight energy, and we like that positioning a little bit more today. So anything to add to that, Lawrence, from the bond market perspective? I mean, it probably takes the risk of a Fed hike down a bit, right?

Lawrence Gillum  (04:11):

Yeah, certainly. I mean, it definitely depends on how long this war skirmish it lasts. And to your point about Iran is spot on. If it spreads and Iran becomes a bigger participant in this event, certainly that'll have more lasting impact, we think. But as it stands now, well, the U.S. bond market is closed today for the holiday, but if you look at the rates markets for non-U.S. developed markets like the U.K., France, Germany, bond yields are all lower as you'd expect them to be, given kind of that risk off sentiment in the bond market given the fact that, you know, there could be you know, a bigger argument for a skip for the November meeting for the Fed, given kind of the geopolitical events that are taking place. So by and large, it's not, it doesn't have a tremendous impact on the fixed income market. It certainly won't have a big impact or lasting impact if this is short-lived. Certainly, the inflationary story is going to be the bigger driver of where bond yields are going. But for today anyway, it does look like the risk off environment in the, you know, non-U.S. developed market is taking place.

Jeff Buchbinder (05:23):

Yeah. And you'll see a little bit of support for precious metals too. Defense companies are certainly seeing a lift that makes perfect sense. You'll probably see Congress come together at some point, <laugh>, given the current dysfunction, we don't know when, but you'll see Congress come together at some point and fund you know, Israel defense as well as more Ukraine funding as well. So, let's transition. There's no good transition out of that, to the market recap for last week. You see here, you know, not only were stocks resilient last week, they're resilient so far today, up a half a percent last week up similarly today, at least as we're recording this. And that whole gain really came on Friday with the reaction to the jobs report. At first, people saw, you know, 300,000 plus jobs and immediately sold, or at least the machines did on the thought that that was, you know, hawkish for the Fed.

Jeff Buchbinder (06:24):

But then when you look one level down, you see that the wage numbers in the jobs report for September were actually pretty calm, actually, better than expected. And then the market kind of changed its mind and reversed solidly higher. So that was really the whole story for last week and why we ended up and you saw the, like a risk on kind of a tilt with you know, the NASDAQ outperforming, tech doing very well up about 3%. The tech heavy comm services sector also did very well, up 3%. That's where Alphabet and Meta are. And then the you know, on the other side of the coin, ironically, you had energy, the worst performer last week as oil collapsed on inventory fears. So you know, we'll get back some of those losses today, of course.

Jeff Buchbinder (07:16):

But energy, a laggard as oil gave back some of those big gains as markets started to focus more on just traditional supply demand in the U.S. and less on geopolitics, at least that was Friday. Obviously, that's flipped in the other direction today, and we really didn't see we saw you know, the gains in the U.S. but really didn't see gains overseas at all. You can see losses in Europe and pretty much Asia across the board. Little bit of a gain in India, a little bit of gain in China. Strong dollar certainly continues to weigh on international equities. Though for now we do have a slight positive bias toward international equities and remain neutral the U.S. So, Lawrence, how about fixed income last week? I mean, you know, the job market was maybe a little bit healthier than people thought, and that puts some pressure on bonds.

Lawrence Gillum  (08:16):

Yeah, so stop me if you've heard this recently, but bond yields were higher last week sixth week in a row. In fact, the bond yields have been higher. We've moved about 0.7% on the 10-year Treasury yield over that six-week time period. So it's been an unrelenting move higher in treasury yields on the back of stronger than expected growth which we'll talk about in just a second, as well as just a glut of issuance coming to market over the next couple quarters in terms of new Treasury securities that the Treasury is going to issue to fund deficit spending. But in the meantime, it's really, frankly, no place to hide across fixed income sectors, yields were higher, spreads were a little wider in the corporate credit markets as well.

Lawrence Gillum  (09:01):

So, it seems like it's kind of getting close to the end of this backup in rates. But you know, we've thought that before given the kind of the unrelenting move, we think that there's going to be a breather eventually and maybe some consolidation. But until that happens, momentum has kind of pushed yields higher and continues to push yields higher. Now, as we talked about a second ago, the bond market is closed today. So maybe there's a little reprieve due to the situation the Middle East. But it's been tough sledding over the past six weeks in particular for fixed income markets.

Jeff Buchbinder (09:37):

Yeah, it sure has. You know, I looked this morning and the odds of a rate hike in November are like mid-teens, very low. And I think the odds of a December hike have come down as well. So this does increase the odds that the Fed is done. But obviously we can't declare that with a high level of conviction just yet. I also want to point out you know, it was a tough week for metals last week, I mean it's been a tough month for metals, but certainly for those who are concerned about a wider conflict in the Middle East, you know, precious metals certainly makes a lot of sense. And frankly, that geopolitical tale set the weak, or the strong dollar, if we continue to get dollar strength, remember, you know, strong dollar usually means weakness in precious metals.

Jeff Buchbinder (10:33):

But there are other drivers to precious metals that can overtake that. So, want to point that out too. So S&P was well, it's up today, but it was you know, well off of its highs over the last several weeks. And now we got to the point on Friday at the lows, we were right at the 200-day moving average, pretty much and very close to this 4,200 level of technical significance. So we would argue from a technical perspective, that was a successful test and is a good thing, is bullish. And you know, maybe that's part of why stocks are up today and part of why they were up so nicely Friday after those early morning losses. Because, you know, the machines like the technical setup.

Jeff Buchbinder (11:22):

So obviously the question is, I have here on this slide now is, are we going to get a fourth quarter rally? We talked about that last week. On average, you get about a 4% gain. So certainly, based on where we sit now, that's possible. But it really, we think is going to be dependent on rates, you know, to some extent, certainly on the Middle East. But really rates is the key. And so with that segue, here's rates. So, technically Lawrence, I know you've talked to Adam Turnquist about the 10-year yield chart, and you know, he tells me 4.9 is the next resistance, and then five. So, do you think we have, you know, are we at risk of breaking above five?

Lawrence Gillum  (12:09):

Yeah, I mean, we're really close to it now, and given the momentum of higher yields that we've seen over the past several weeks and months, I mean, it's certainly possible. If you also think about the fed funds rate and the yield curve just in general for the U.S. Treasury securities, a lot of those securities are already above 5%. We hit 5% on the 30-year last week as well. So, 5% is doable for sure, which I'm still in awe of the, you know, the economy's ability to handle 5% Treasury yields. But so far so good in terms of you know, the economy continuing to grow and digest these higher yields. But 5% is certainly doable, for sure.

Jeff Buchbinder (12:56):

Yeah, I'll take a good economy with high rates over a bad economy with low rates any day. So, there's the glass half full take on that, but yeah, there's really not a ton of resistance if you get up above five. We'll keep watching this, but you know, maybe you taught me this, Lawrence, maybe the best thing about higher rates is that they attract buyers of bonds because bonds look better.

Lawrence Gillum  (13:22):

Yep. And I think what's interesting is that there's very little resistance there, because it's been such a long time since we've had yields in this range, right? So, I mean, we had, we went a whole decade, you know, without yields above or the fed funds rate above zero, right? So, we're in a new regime. We think we're in this higher for longer regime, which we'll talk about in just a second. But because of that absence of higher yields over the past decade, once we break some of these overhead resistance levels, it, I mean, there's not a lot of technical support for you know, anytime soon, which could keep pushing yields higher.

Jeff Buchbinder (14:00):

Yeah, I've heard talk of the bond vigilantes <laugh>, right? Pushing yields higher to force fiscal discipline on the federal government, and that's going to happen eventually, you know, who knows when. But you know, the U.S. debt is much more expensive to service as you get at higher interest rate levels. I know you wrote about that recently, Lawrence you know, this, the economy, I mean, we don't know when the economy is going to start to slow. We haven't really seen a lot of evidence that it's starting to happen yet, but when it does, it's going to be hard for yields to keep moving higher. So that's probably the point where bonds start to look really good, even though they, we think they look pretty good right now. So last chart before we get into the next segment here.

Jeff Buchbinder (14:48):

I wanted to show this correlation chart and make the point that the relationship between stocks and bonds changes depending on the levels of inflation. Okay? I know there's a lot going on in this chart, but it's a very simple concept. We have high inflation now. So stocks and yields move in opposite directions, okay? If we had low inflation, stocks and yields would move probably in the same direction, right? You want more growth when you're in a low inflation environment. You want more growth, you want yields higher. We don't want yields to reflect more growth and more inflation anymore, right? We used to want that <laugh>. Now we don't. And so that means that for now, and probably in the near term, we need yields to go down for stocks to go up, right? Stocks are really kind of following the bond market's lead, as I said in earlier slides.

Jeff Buchbinder (15:47):

So the good news here is that we do think yields are eventually going to head down, and that's going to be good for stocks. And then you can take that a step further and say, the market eventually won't care as much about yields or as much about movement in interest rates, because inflation's coming down, and maybe we won't get to the Fed's target for another, you know, 18 months or something. But once we get down there and we think we will, then we can get past this obsession with interest rates and the Fed, and that'll certainly be a good thing for stocks. So, I thought that was a very interesting point to make. We're still, as stock investors, we're still kind of you know, prisoners of the bond market. So, let's go through the jobs report real fast. So, you know, north of 300,000 jobs, way more than consensus, which was around 160, depending on your source, basically double that.

Jeff Buchbinder (16:44):

And you know, we also had upward revisions to the prior two months. So, it was like, you know, it was like doing 450 to 500,000 when you factor in the revisions. Now you know, the market looked at the composition of the job gains and saw, you know, strength in leisure and hospitality jobs, strength in education jobs, government jobs, generally speaking, lower wage jobs made up the bulk of the new jobs that were created in September. So that's how you get this blowout job creation as you see here. And this little uptick in the six month moving average in the orange line to a better story on the wages front, right? It's a mix shift. So, we had a decline in the year over year average hourly earnings change or wages, right? It was a little better than expected on a month over month 0.2% rather than 0.3. And then your year over year was you know, continued to come down, right? You see that in the orange line. So, 4.3%. So, this continues to be a good story. I mean, it's slow to come down, but it continues to be a good story for the economy and for the Fed as wage pressures abate, even though we have strong job market. So, anything to add to that, Lawrence?

Lawrence Gillum  (18:19):

Yeah. I think one of the things.

Jeff Buchbinder (18:19):

Did the bond market interpret this correctly?

Lawrence Gillum  (18:22):

Yep. So one of the things I think that the bond market looked at and said that maybe this wasn't as you know, impressive as the headline numbers would suggest, that if you look at things like the number of workers with multiple jobs that started climbing, again, indicating that there's some part-time work out there that's increasing, particularly as that excess savings start to dissipate, number of self-employed increased as well looking, you know, again, for additional sources of income. So you know that headline number was obviously extremely impressive. But maybe there are some reasons why that you know, there's a lot of jobs being added. And then if you look at the household survey, which is separate from the survey that we're looking at on the previous screen, there's two job surveys that are released on jobs day.

Lawrence Gillum  (19:10):

There's an employment survey, and then there's, or I'm sure there's an establishment survey, and then there's a household survey. The household survey wasn't as robust. So that one looks at individual households and say has your employment picture changed at all. And that partially gives credence to that multiple part-time job story. Because it wasn't as impressive as that establishment survey at the 336,000 jobs. So, I think the bond market initially saw it as like, wow, you know, the Fed has to do more, but then when you look under the hood a little bit, it wasn't as robust as maybe the initial headline number would suggest.

Jeff Buchbinder (19:50):

Yeah, good point. And then in survey data, we've seen businesses planning to hire less, right? So, there's a number of indications like that, that suggest that the job market is cooling. You just don't see it in that, you know, 350 number that we saw last Friday. So thanks for that, Lawrence. So, you know, here we're kind of putting you on the spot. I mean, I've sort of asked you this already <laugh>, but where do rates go? And I know you changed our forecast for year end and I, and we don't have a 2024 forecast, but, you know, generally speaking, based on where you see the world today, you know, where do you think yields may be headed between now and year end and then early 2024?

Lawrence Gillum  (20:37):

Yeah, it's hard to believe that 2023 is coming to an end. We're in the process of updating our 2024 Outlook piece. We got to start working on that, Jeff, here shortly. But this end of year target has changed coming into, you know, we'll call it the mid-year outlook piece. We thought the 10-year Treasury yield would end the year between 3.25 and 3.75. That was on a slowing economy, a less hawkish Fed, maybe the Fed took the fed funds rate to 4.5%. At 5.5% the Fed has, you know, moved up, moved through that four a half percent target that we we're kind of looking at. So, we did update our forecast for the end of the year for this year which will certainly bleed into 2024 as well.

Lawrence Gillum  (21:25):

This year we think rates are kind of where they're at right now. So, 4.25 to 4.75 is our target. We're at 4.8% right now. We do think that as the economy continues to digest these higher rates, there's some potential speed bumps in the way of a robust economy, you know, the interest expenses are going to go up for companies and consumers. We got you know, higher, higher levels of prices and higher rates for things like auto loans and mortgages and credit cards. So, we do think maybe the economy slows towards the end of this year. So, it should take some pressure off of the 10-year Treasury yield. So, we think that the big move in yields has already happened, but that said, you know, the economy continues to surprise to the upside.

Lawrence Gillum  (22:17):

That's the chart we're looking at here. This is the Bloomberg Economic Surprise Index. Since May, the economy has continued to outperform economic expectations and that has pushed yields higher alongside those positive surprises. So, the bond market had been pricing in a slowdown, an economic contraction. If you go to the next slide the, you know, the bond market was pricing in recession, right? That's what happens, or what has generally happened when the U.S. Treasury yield curve inverts. You get this situation where the bond market starts to expect rate cuts due to a slowing economy that ends up inverting a yield curve. And right now, the bond market is pricing out those rate cuts, in fact, so we're starting to see that dis-inversion. We've come a long way in terms of that dis-inversion. 2-year treasury yields out yielded the 10-year Treasury yield by about a percent early in, I want to call it July. We're about at 0.25% now. So, the inversion or the dis-inversion has moved a lot, but as long as that dis-inversion is still negative there, as long as the U.S. Treasury yield curve is inverted you know, there's the risks that intermediate and longer-term yields can still go higher. So, 4.25 to 4.75 is our target with risks that maybe we see 5% this year or potentially early next year.

Jeff Buchbinder (23:47):

So, I know Lawrence, yeah, everybody focuses on the initial inversion of the yield curve as a recession signal, right? Very popular recession signal. But the lag is really long, right? In some cases, it takes a couple of years. I mean, if you, if you lengthen your recession call long enough, you're going to be right every time, because eventually we have a recession no matter when it is. So my question is, how about the signal of dis-inversion or sort of normalizing, I mean, obviously that gets you closer to recession. You know, does that potentially increase the chances that over the next two, three quarters, that the economy slides into recession, or no?

Lawrence Gillum  (24:28):

Yes and no. And this is where it may get a little wonky so I apologize, but there's a couple of, there's two ways that an inverted yield curve can dis-invert. You can either have the 2-year Treasury yield fall in anticipation of Fed rate cuts, or you can have the 10-year Treasury yield rise in anticipation of a higher for longer Fed. So pricing out rate cuts. So the first one is called a bull steepener. We have our own language in fixed income world. The first one is called bull steepener, which means the front end of the yield curve goes down. That's positive for bonds. That means that the bond market is pricing in Fed rate cuts. And that has typically been a very good sign that recession is close, right? The market starts to price in rate cuts because the economy is slowing.

Lawrence Gillum  (25:17):

The Fed usually cuts rates to help stimulate the economy, et cetera. What we're seeing now is called a bear steepener. These are much more rare and what we're seeing now is the long end of the yield curve kind of catch up to the front end of the yield curve. So, the back end is selling off as these rate cuts that were expected by the market get priced out. So this is generally, at least initially not a great signal in terms of recession. That said, as these longer-term yields go higher, the cost to borrow increases as well, which could paradoxically, as the bond market's pricing out these recession risks, could actually increase the risks. So, it's kind of, like I said, it's kind of wonky, but you know, the more reliable signal, or a little more straightforward signal, I would say is when the, when the 2- year Treasury yield starts to fall, this one, it doesn't have a great track record, but it does, you could argue increase recessionary risk because the cost to borrow increases pretty significantly.

Jeff Buchbinder (26:22):

Yeah, great points. And you I think are seeing the at least some of the Fed speakers today, acknowledging that the bond market's doing some of the work for them, right? Higher interest rates mean market-based interest rates, like the 10-year, mean, maybe the Fed doesn't have to do as much in terms of hiking the fed funds rate. So, you know, we would have more conviction that the Fed has done now than we had probably a few weeks ago. And then you add to the equation higher oil prices, if we do get that, and that adds even a little bit more pressure to the economy. So, you know, we still think that if we have recession, it'll be very mild and short-lived. But the odds that we do get one over the next few quarters have risen, no doubt.

Jeff Buchbinder (27:07):

So good discussion there, Lawrence. I mean, I can't believe it. I'm an equity strategist and I actually followed everything you said there, shockingly, but I really think I did. Quiz later, right? Quiz later. So let's go into the preview the week ahead. I mean, as I mentioned up front, I mean, it's going to be all eyes on the Middle East. That is a potential tinderbox to put it mildly. And so that will, you know, with regard to the energy markets and frankly the economy, if it spreads, will be the main focus I think for folks in the days ahead. But beyond that we have CPI this week, and we have the start of third quarter earnings season. This earnings season is going to be really interesting because you have a strong economy, you have some inflation still, and wage pressures are coming down, or generally cost pressures are coming down.

Jeff Buchbinder (28:10):

So, and revisions are good, right? Estimates have actually held up really well. So all that would line up normally for a really good earnings season, right? Relative to expectations. However, the dollar has essentially been a straight lineup since companies provided guidance last quarter, right? So that's going to limit how much upside we can get. So, you know, instead of maybe four or five points being the base case, we would say maybe two or three points of upside should be the base case. Because the dollar is that big of a headwind for international earnings, right? About 40% of S&P 500 profits come from outside the U.S. and other currencies. And then you know, if the dollar's strong that eats into those foreign source profits. So, it's going to be tough for the market to grow, the S&P 500 at least, to grow earnings more than, let's call it three or four points.

Jeff Buchbinder (29:13):

But we think with consensus right now to up a half a point, which means the end of the earnings recession we think a plus two plus three is a very reasonable expectation. Now, the next question is, is that enough to move the market? Given everything that's going on, maybe not, and it'll be enough probably to move the energy market, right? Energy companies we think are just going to have a blowout quarter and that remains our favorite sector. We still like industrials as well, so we think with energy and energy-tied investments we think are going to do very, very well because, you know, for most of the quarter, oil was rising and we've seen positive revisions in energy stocks. That looks like a really good place for upside surprises. But beyond that it's just going to be a little bit tricky with that international drag.

Jeff Buchbinder (30:03):

So, we'll see. Hopefully it is a positive catalyst and helps us get to that Q4 rally. Maybe just getting us focused on something other than yields will be positive. But you know, we don't think we're going to be in this situation where, you know, companies blow out the numbers and, and forward estimates go up again. If they hold up, that's a win. So, and by the way, Q4 estimates are probably too high, plus 9% Q4, that might be a little bit of a stretch. So, turning the economic calendar, I mean, I think it's all about CPI. You know, we had energy prices go down during September, so that should be good, but now obviously they're reversing higher now. So we'll see about what happens in you know, the next couple of months.

Jeff Buchbinder (30:51):

But, you know, this is still a good story. Year over year CPI, looking for 3.6% core ex food and energy 4.1, we're getting very close to having a three handle on core CPI, and we're right around there on the core PCE, the Fed's preferred inflation measure. We have been saying pretty much all year, we thought we can get to the mid threes and looks like we're still on track for that. So, I think CPI is going to be the highlight. Anything else here Lawrence, that you would highlight that might be interesting, maybe the Fed minutes?

Lawrence Gillum  (31:26):

Well, interesting for the bond market anyway, is just all the Fed speakers. You've referenced a couple of them today. There's a ton of them out there this week. I think I counted 12 or 13 different speaking engagements for Fed officials. And then of course the Fed FOMC meeting minutes will be released, I believe, on Wednesday. That could be interesting given the hawkish pause that we saw last meeting and kind of the discussions around their interest rate projections. So, for the bond market, it's certainly CPI, but also the Fed speak that we're hearing today and likely to hear throughout the rest of this week as well.

Jeff Buchbinder (32:07):

Very good. I think given the barrage of economic data last week, we could use a break. We'll get through the CPI and then things will be quiet, at least based on the economic calendar anyway. So, with that thank you all for joining another addition of LPL Market Signals. Lawrence, thanks for being here. I really needed you this week because it was pretty much bonds and rates all day long. And as you know, I cannot do a call on bonds and rates by myself. So I appreciate you. I guess with that, we'll go ahead and sign off. Thank you for joining everyone, and take care. Have a good week.