It was a critical week for stocks, with the S&P 500 down 10% over the past three months heading into a week full of key events that could have brought on weaker sentiment and more volatility. However, the news coming out of several events was not as bad as feared, leading to one of the strong rallies of the year, for both stocks and bonds.
Heading into the week, stocks were experiencing oversold conditions and a steady increase in short positions (where investors bet on stocks to decline), particularly by hedge funds. But markets were met with a perfect set up with November beginning on Wednesday and entering the strongest part of the year.
According to Bloomberg, markets saw the largest cross-asset rally last week since November 2022, driven by Fed Chairman Powell taking a less hawkish tone, with stocks, bonds, and credit rising in tandem. Other items driving the rally was a better than feared Treasury borrowing plan for the next three months (see “other news” section below), softer economic data, better earnings reports, a spike in short positions that created a short squeeze, oversold conditions, and strong seasonality. The S&P 500 and NASDAQ saw their best week of the year, rising 5.9% and 6.6% respectively, while Treasury yields saw the largest decline since March with the 10-year note falling 32 basis points to 4.52%, the lowest since September.
The three weeks leading up to last week saw selling by hedge funds that Goldman Sachs said was the second biggest selling spree of the past decade as recessionary worries mounted. In addition, short bets on US Treasuries were right near the highest levels since records began. Short positioning within stocks played an important role as well – a basket of the most shorted stocks rose 13%, according to Bloomberg, versus the average stock rising 5.9%. Meanwhile, rate-sensitive growth and speculative stocks fared even better, rising nearly 20%, while the small growth style rose over 7%. At the same time, defensive sectors like consumer staples and health care rose less than 3.5%.
The technical factors (like short positioning, oversold levels, and seasonality) were only one side of the rally. The other was the weaker economic data and most recent FOMC meeting. Data last week centered around the labor market and employment costs – job openings held steady, jobless claims increased slightly, ADP reported less payroll gains than expected, while the DOL said less jobs were added than expected and the unemployment rate increased. At the same time, employment costs held steady, wage growth cooled, and unit labor costs surprisingly declined. Labor market data is a lagging indicator, but this was all consistent with a slowing labor market. This is good news on the inflation front and provided ammunition for the Fed that additional rate hikes may not be necessary.
However, in our opinion, this is also consistent with data that we see prior to an economy falling into a recession.
The FOMC meeting came between all of this data, so the Fed was not able to take all this into consideration prior to their policy decision Wednesday afternoon, and prior to Chairman Powell’s press conference in the afternoon. The Fed decided to make no change to monetary policy, keeping interest rates at 5.38%. In the policy statement it upgraded its assessment of the economy, describing economic growth as “strong” versus “solid” and job gains that have “moderated but remain strong” versus “slowed.”
But market reaction really came after Powell’s press conference, where investors saw his tone as slightly more dovish, but we thought it was consistent with the September meeting. Powell refused to say that policy was “sufficiently restrictive” but that we were closer to that level and left out the possibility of additional rate hikes. As with last meeting, the Fed will make its next decision at the time of the meeting based on the totality of the data and information it receives on the economy and progress toward stable inflation. Powell talked a lot on how tighter financial conditions will impact the economy going forward and how the full effects of interest rate increases have still yet to be felt fully throughout the economy.
As we have mentioned previously, it typically takes 12-18 months to feel the effects of rate increases. The first rate increase was March 2022, almost exactly 18 months ago, and the Fed did not begin to aggressively raise rates until July. The last rate increase was July this year – this tells us there is still a lot of time before the full effects are felt, and another reason we believe there will be continued slowdown in economic activity and potential recession.
The expectation for a rate cut was pulled ahead to June 2024 after the meeting, up from July prior to the meeting. Stocks took off after the adjustment in expectations while Treasury yields plunged to the lowest level in two months, making it the largest rally in Treasuries since the outbreak of the pandemic March 2020.
With markets moving into a seasonally strong part of the year (November and December are the best two months of the year), strength is likely to continue over the short-term, but risks remain and the outlook is murky, which we think will continue to lead to significant volatility heading into 2024.