Over the past few months, the stock market has been like a toddler learning to swim – lots of kicking, splashing, and screaming, but ultimately little progress in any direction. Interest rates have risen dramatically as investors hang on Fed Chairmen Kevin Warsh’s every word. Oil prices have fluctuated wildly with each escalation and de-escalation of the conflict in Iran. And the outlook for artificial intelligence has cycled from pure optimism to concern about doomsday scenarios. Despite all that agitation, the stock market has traded in a narrow range for months. In fact, the S&P 500 closed September less than 1% above its June 2nd level.
The story of the markets in September was interest rates, as the yield on the 10-year Treasury rose almost 0.50 percentage points to 5.25% - its highest levels in more than 20 years. Normally, such a sharp increase would be expected to cause more damage to the stock market. Higher rates increase borrowing costs throughout the economy and make stocks somewhat less attractive relative to bonds. Yet the S&P 500 finished September only modestly lower and remains up double digits for the year. In our view, the market's resilience provides an important clue about what is currently driving interest rates higher.
Interest rates can rise for good reasons or bad reasons. Rates sometimes rise because inflation is accelerating or investors are becoming concerned about financial stability. Those are generally unfavorable developments. But rates can also rise because economic growth is stronger than anticipated and demand for capital is increasing. We appear to have some of both today, but the data suggest that the good reasons are playing a larger role.
We have written extensively about the absence of significant problematic inflation; market-based measures of inflation expectations and performance of inflation-protected bonds continue to support that view. We do think it is reasonable that concern over federal deficits accounts for some of the rise in interest rates. But the larger factor appears to be the strong economy. Unemployment has remained historically low. GDP growth has been consistent and may be accelerating as the Atlanta Fed’s GDP Now currently project 3.7% annual growth in Q3. And corporate profit growth has been exceptional. A strong economy, combined with heavy borrowing and investment tied to the data center buildout, explain much of the rise in interest rates in our view. And while higher interest rates are a headwind for stock valuations, the tailwinds from economic and profit growth have been strong enough to offset the negative impact up to this point.
Of course, if rates rise high enough or quickly enough, there is a level at which they will negatively impact the stock market. Pinpointing that level is difficult to do in advance. We would point out that data from asset managers and the CFTC suggest that investors are positioned heavily for interest rates to continue rising. Consensus trades are rarely right for very long and are vulnerable to sharp reversals. Given a catalyst, conditions are right for a potential sharp move lower in interest rates.
We wrote last month that September and October represented the most likely window for a potential stock market decline. That window is still open. Interest rates, the conflict in Iran, or midterm election uncertainty could lead to a market pullback. In addition, we have seen some deterioration in the balance between buying power and selling pressure as measured by Lowry’s Research, an important indicator in our process. We are not predicting that a correction must occur. But we want clients to be prepared for that possibility, so the normal market volatility does not become a source of unnecessary concern.
More importantly, the weight of the evidence continues to suggest that any pullback in the coming months would most likely represent a temporary setback within an ongoing bull market rather than the beginning of a sustained downturn. We will continue to follow our investment process to guide client portfolios through any volatility, including identifying potential buying opportunities as they emerge.
This is being provided solely for informational and illustrative purposes, is not an offer to sell or a solicitation of an offer to buy any securities. The factual information given herein is taken from sources that we believe to be reliable but is not guaranteed as to accuracy or completeness. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed here.
