All good things must eventually come to an end. In August, equity markets snapped five-month winning streaks to post their first monthly drops since mid-winter. Market volatility increased during the month, as equities pulled back on renewed angst concerning Chinese growth and questions surrounding the ongoing inflation and interest rate spectacles. Small-capitalization stocks fared the worst, down -5% on the month, while the tech-heavy NASDAQ was least bad at -1.5%. The S&P500, the most tracked and referenced market index, fell -1.6% in August to land right in the middle of the pack. Despite these negative performance figures, most major indices rallied during the last week of the month to close well off their August lows, clawing back respectable gains just prior to the Labor Day holiday.
One of the more immediate contributors to the August sell-off was Chinese economic growth, in which credit and deflation data both came in softer than forecasted. To boot, the People’s Bank of China (PBOC) cut its prime rate by 1.1%, which was unexpected and cast doubt on the country’s post-COVID recovery. Unfortunately, the world’s second-largest economy remains stuck in the economic mire, struggling to bounce back from its strict pandemic policy response. Back home, our government had its own share of trouble, with Fitch downgrading its credit rating by one notch (AAA to AA+) based on rising debt at the local, state, and federal levels. In a statement that sounded like insult added to injury, Fitch cited a “steady deterioration in standards of governance” over the past decades. Despite the somewhat odd timing, market reaction was muted as both equities and fixed income looked forward to other, “more important” data.
That “more important” data was, as it has been for the better part of 18 months, inflation and interest rates. Regarding the former, July’s headline CPI reading was in line with expectations, up 3.2% on an annual basis compared to 3.0% in June. This slight uptick was the first monthly increase in the reading since July 2022, mostly driven by increase in shelter. While technically this indicates inflation falling at a lower clip, there were no hawkish surprises in the report and the markets took the number in stride. Regarding interest rates, Federal Reserve Chairman Powell struck a centrist tone in his annual Jackson Hole speech, reaffirming both a data-dependent approach and the bank’s commitment to a long-run inflation target of 2%. Accordingly, the fixed income markets priced in a 40% chance of a final 2023 hike, and now suggest up to 4-5 rate cuts in the new year. While only time will tell what the realized path of interest rates will be, the consensus seems to be that we are in the 8th or 9th inning of the hiking campaign, and accordingly the vast majority of interest rate pain is behind us. Good news for bond investors moving forward.
S&P500 earnings continue to decline, posting their third straight quarter of annual reductions, dropping 5.2% year-over-year in Q2. The energy sector has been the biggest drag on S&P earnings, reporting an aggregate -51.4% decline in profits (which fairly included some very challenging 2022 comparisons stemming from the Ukraine war and global commodity inflation). Bucking this trend for a second consecutive quarter was Nvidia, which posted blowout earnings to the tune of a 101% increase in annual revenue ($13.51B in Q4). The tech company has now firmly cemented itself as the bellwether for the emerging AI boom, and the market has rewarded the company with a market cap of over $1T!
Looking forward, we enter a seasonally weak period for equities. September has not been the brightest month historically, with the S&P500 losing an average -1.08% for the month during the last 50 years. That said, the goldilocks scenario of a soft landing still has legs, despite the volatility that we saw in August. Close attention will be paid to China’s difficulties and, closer to our own shores, the one-two combination of interest rates and inflation. Should that data be in line with market expectations, there is no reason for the rally not to continue.