Tightening financial conditions, persistent inflation and a mixed earnings outlook could make for more stock-market turbulence. Here’s how investors can prepare.
Key Takeaways
- Benchmark U.S. stock indices dropped sharply last week as investors appeared to confront new economic concerns.
- Financial conditions are tightening, just as surging GDP growth pressures the Fed to keep interest rates higher for longer.
- Mixed corporate-earnings results and cautionary commentary by key companies further cloud the outlook for investors.
- Value-oriented opportunities are emerging among financials, U.S. small- and mid-cap stocks, and international stocks.
What caused last week’s stock market correction?
Rising interest rates. Hawkish Federal Reserve rhetoric. A stall-out in progress on reducing inflation. Geopolitical conflict.
Any one of these developments might typically be enough to knock the U.S. equity market off course, but for much of this year, stocks rallied as investors appeared to shrug them off.
However, it seems the equity market has finally started to re-assess the investing environment. The S&P 500 Index fell 2.5% this past week, bringing the index down 10% from its recent high in July. The Nasdaq fell 2.6% last week and is off 12% from July. Both benchmark indices finished the week in a “correction,” defined as a fall of at least 10% from a recent high.
So, what has changed? We believe stock investors finally awoke to at least three realities:
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1Financial conditions have finally begun to tighten.
Conditions eased for most of last year despite rising interest rates, but it appears that a recent confluence of circumstances—U.S. dollar strength, resurgent oil prices, a slowdown in lending and widening credit spreads—has finally begun to drain market liquidity. For equity investors, this can mean fewer buyers in the market and a resulting decrease in demand for stocks. Tighter financial conditions also tend to be a drag on economic growth, which tends to weigh on corporate earnings. The Goldman Sachs financial-conditions index has tightened by about 2% since mid-July, drawing almost a perfect inverse correlation to the decline in the Nasdaq.
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2The economy remains strong.
New data show that U.S. gross domestic product (GDP) had its strongest quarter since 2021, growing at a blistering 4.9% annual rate in the third quarter (adjusted seasonally and for inflation). On its face, this strength was a testament to consumer resilience and labor-market strength, but it also means that 18 months of Fed rate hikes haven’t quite put the intended chill on the economy. That suggests the Fed may have to hold rates higher for longer, given the risks of persistent inflation—which, by the way, accelerated in September. Meanwhile, the momentum in consumer spending may not last, as household savings run down and spending outpaces income growth. Both high interest rates and decreased consumer spending dim the outlook for stocks.
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3Ambitious earnings expectations may be tested.
Wall Street analysts and investors have been projecting strong company earnings growth in 2024 and 2025, but that outlook is worsening. As the third-quarter earnings season plays out, a mixed set of forward guidance and cautionary commentary by key companies may be reminding investors that the current backdrop of robust GDP growth is not sustainable and could set the bar uncomfortably high for results in 2024.
Looking Ahead
The way we see it, the stock-and-bond selloff in January–October 2022 marked Phase I of the current bear market. While some investors viewed the equity-market rally in October 2022–July 2023 as a new bull market, we see it as a mere retracement, or Phase II, of a continuing bear market. And today, we believe we are seeing Phase III, a period of potential volatility for both stock valuations and corporate profitability, in which stock indices remain rangebound. In this environment, short-term traders may find tactical opportunities, but long-term investors should stay patient and maintain a strategic outlook.
Consider using current market volatility to execute tax management strategies and rebalance portfolios toward investments that offer yields. Investors may also look at stocks with quality cash flows that are fairly priced based on achievable earnings targets. Value-oriented opportunities are emerging among financials, U.S. small- and mid-cap stocks, and international equities.
