An already weak third quarter was capped by a sharp September drop in markets. The S&P 500 lost 9.21 percent for the month and 4.88 percent for the quarter; the Dow Jones Industrial Average dropped 8.76 percent for the month and 6.17 percent for the quarter; and the Nasdaq Composite fell 10.44 percent for the month and 3.91 percent for the quarter. Markets resumed their downward trend in August and September after a bounce early in the quarter. Internationally, we saw the same behavior, with both developed and emerging markets down sharply in September and for the quarter. So, let’s take a look back at what drove these declines and then evaluate what it means going forward.
Rates drove declines. As it has been for most of the year so far, interest rates drove the markets in the third quarter. The Fed raised rates aggressively during the quarter. On two separate occasions, at the Jackson Hole central banking conference and in the press conference for the September Fed meeting, Chair Powell repeatedly committed the Fed to continued rate increases until inflation is under control—even if that leads to economic weakness. The strong commitment to higher short-term rates drove rates up across the curve, rattling markets and undermining a previous market assumption that the Fed would pause increases in the event of a recession.
Looking back, we can see that in the data. At the start of the quarter, the U.S. Treasury 10-year yield was 2.974 percent, which rose to 3.804 percent at quarter-end. Higher rates typically mean lower stock valuations, and this was a significant driver for the weak performance last quarter. Looking forward, that rise in rates has continued in early October, so there could be more pressure on markets.
Growth worries rising. Higher rates have also started to weigh on growth. While some metrics remained strong last month, signs of a slowdown were apparent as well. Employment growth, although still healthy, slowed during the quarter, from 537,000 in July to 263,000 in September. Business and consumer spending growth were both down, while the housing market has slowed dramatically. While recession worries moved away from the headlines, worries about earnings remained. A slower economy typically leads earnings down, and analyst estimates of future earnings continued to decline throughout the quarter.
Looking forward to the third-quarter earnings season, investors remain cautious about the outcome, and that will likely continue to weigh on markets.
Positive trends emerge. Looking forward, though, there are positive trends as well. Consumer confidence has started to recover, and more people are moving back into the labor market. Gas prices continue to decline, and inflation has started to move down. While there are headwinds, they could continue to moderate through the rest of the year, supported by the substantial momentum the economy still has.
Some risks beginning to fade. Finally, the fourth quarter should see other worries moderate, too. The risks from the war in Ukraine continued to subside during the third quarter, and that trend is likely to continue. Inflation is showing signs of moderating, even as supply chains are normalizing. Overall, looking forward to the rest of the year, the economic risks of the major international issues look likely to continue to fade.
A historically risky month. That’s not to say we will not see more turbulence, as the risks out there are real. Interest rates have been rising in early October. Covid-19 could surge again and disrupt things, here or abroad. Above all else, with the midterm elections approaching, expect more political turbulence. October is historically a risky month. When and if those bad things happen, we will see more market volatility.
Better prospects ahead. At the same time, the prospects for the fourth quarter look better than the third. The good part of the weak third quarter is that much of the damage to the economy and markets may have already been done. For the economy, inflation is showing signs of fading even as economic growth continues. For the markets, midterm years have often been very volatile (as we have seen). But after the elections, markets have tended to rally.
Looking forward, the reduction in all forms of uncertainty—around inflation, the Fed, the economy, and politics—should help support markets. If job growth remains healthy, and with worries starting to moderate, we could see valuations stabilize and possibly improve. We may even see some appreciation as fears about earnings growth moderate.
What’s the Bottom Line?
Looking back at the third quarter, we saw the Fed get serious about inflation and markets drop as investors got the message. As we move on to the fourth quarter, the news is already out—and we are at least part of the way through the process. The third-quarter pullback reflected the real changes in policy and risk. Looking forward, while those risks remain, most of them are likely incorporated into markets, meaning the further effect should be limited.
Big picture, the third quarter was very difficult on many levels, and the September performance was especially bad. But, unless we see the fundamentals continue to deteriorate (and that is not what we are seeing), the fourth quarter may end up better.
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Disclosure: Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Bloomberg Barclays Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Bloomberg Barclays government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Bloomberg Barclays U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.