United States
Surge in longer-term U.S. Treasury yields pressures equities into correction territory
Equity markets continued their decline in October, with the S&P 500® down 10% from its peak in late July. The sell-off was fueled by a surge in longer-term Treasury yields and the U.S. Treasury’s (UST) elevated borrowing needs. The index ended October down 2.1% for the month, its third consecutive monthly decline, as higher interest rates and mixed earnings results from several mega-cap stocks pressured markets lower. Rising interest rates have entered restrictive territory for smaller companies with levered balance sheets and lower operating margins. This has been evidenced by the S&P MidCap 400® experiencing its worst two-month stretch since August-September of last year, and the Russell 2000® remaining in a correction since mid-September.
Treasury yields continued to move sharply higher, with the 2- and 10-year U.S. Treasury yields reaching new 16-year highs. The 10-year Treasury yield surged toward 5%, causing the slope of the yield curve, as measured by the spread between 2- and 10-year yields, to steepen to its highest level in over a year (Figure 1). Due to the jump in Treasury yields, fixed income volatility, as measured by the MOVE Index, increased to the highest level in five months. Fixed income markets came under pressure, and the Bloomberg U.S. Aggregate Index declined for the sixth consecutive month. Despite the rise in yields, below-investment-grade credit spreads increased moderately during the month and currently sit near their 10-year average. While we are closely monitoring earnings season for weakening fundamentals, credit spreads have yet to indicate signs of stress.
Figure 1. Yield Curve Changes
Inverted yield curve is further complicated by a bear steepener
As of 10/31/2023. Source: Bloomberg, L.P.
View accessible version of this chart.
Despite what the broad market declines may suggest, the U.S. economy remains remarkably resilient, largely due to the continued strength of the labor market and consumer spending. The initial third quarter GDP reading accelerated to a 4.9% annualized rate, both above the consensus estimate of 4.5% and more than double the prior quarter’s growth rate of 2.1%. The headline number was driven by personal consumption and increases in both inventories and government spending. Despite the economy’s strength this year, we expect tighter credit conditions and the cumulative effects of the Federal Reserve’s (Fed) aggressive monetary policy to cool economic activity and lead to a mild recession in mid 2024.
Labor market strength continues to support the economic backdrop and fuel consumer spending. The October payroll report showed a surge of 336,000 net new jobs, a significant upside surprise versus the consensus estimate of 170,000. For perspective on current labor market strength, the number of net new jobs added during October ranks among the top five monthly totals during the entire 2009-19 business cycle. Additionally, inflation-adjusted wage growth has remained positive for five consecutive months, which indicates that high inflation is no longer restrictive to consumer spending.
The September Consumer Price Index reading came in unchanged at 3.7% due to higher energy prices. Additionally, the Fed’s preferred inflation indicator, Core Personal Consumption Expenditures, continued to moderate, falling to 3.7%, the lowest level since May 2021. However, both inflation measures remain above the Fed’s 2% target. Consumer sentiment weakened further in October, as expectations for 1-year forward inflation rose to 4.2% from 3.8%.
Given the market pullback, equity valuations compressed for a third consecutive month. The S&P 500 forward price-to-earnings ratio (P/E) fell to the lowest level since last December and is also below its 10-year average. Although valuations have moderated, we expect further negative revisions to earnings estimates as global economic activity continues to slow, lending standards remain restrictive and loan growth rapidly falls.
With over half of the S&P 500 having already reported third quarter earnings, the blended earnings growth rate (consensus estimates combined with actual results) has improved to 3.0% versus the consensus estimate of -0.4% at the start of earnings season. However, the improvement stems almost entirely from the “Magnificent 7” — Apple Inc.; Microsoft Corp.; Amazon.com, Inc.; Alphabet Inc.; Nvidia Corp.; Tesla Inc. and Meta Platforms, Inc. Excluding these companies, the blended growth rate falls significantly to -3.5%. Similarly, the fourth quarter estimate ex-Magnificent 7 has weakened from 2.4% to -2.9%, suggesting the earnings recession may not be over. With leading economic indicators still pointing toward a contraction, we believe the 2024 earnings growth estimate of 12% is overly optimistic and suggests valuations have not yet fully priced in even a mild recession.
Developed International
Earnings recession likely amid gloomy economic outlook
Developed international equities fell for a third consecutive month, with the MSCI World ex USA Index ending October in correction territory, down more than 10% since its July 31 peak. With the exception of Portugal, every country in the index was down, as was every sector, challenged by ongoing economic weakness, rising interest rates and U.S. dollar strength.
Unlike in the United States where interest rates are moving higher in response to strong economic data, Eurozone interest rates are moving higher despite weakening data. For example, the first estimate for third quarter GDP not only surprised to the downside, but also marked the first time since second quarter 2020 that the estimate entered negative territory. In contrast, the yield on the 10-year German bund reached a 13-year high of 2.9% during October. Given the diverging economic backdrop, traditionally cyclical sectors, such as Industrials and Consumer Discretionary, declined on reports of weakening data. Interest- rate-sensitive sectors, such as Financials and Real Estate, also declined, but on the continuation of restrictive monetary policy.
The major central banks maintained restrictive policy rates in October, in continued pursuit of lowering inflation, which remains well above their respective targets. For example, the European Central Bank (ECB) policy rate remained at 4.0%; however, as economic growth has weakened, Eurozone inflation has fallen to 2.9%, the lowest level in more than two years (Figure 2).
Figure 2. ECB Policy Rate vs. Eurozone Inflation (%, y/y)
ECB monetary policy back to a restrictive level not seen since 2007
As of 10/31/2023. Source: Bloomberg, L.P.
View accessible version of this chart.
As such, year-over-year retail sales growth fell for an eleventh consecutive month, and industrial production fell 5.1% on a yearly basis. As geopolitical events in the Middle East add to commodity price risk that is already heightened due to the ongoing Russia-Ukraine war, the Eurozone Producer Price Index fell 11.5%, marking the fourth month of negative growth as inflationary pressure gives way to deflationary headwinds.
In Japan, the largest index constituent, economic data also surprised to the downside and the yen weakened to its lowest level since 1990, despite supportive central bank policy. Equity and bond markets were also impacted by negative earnings.
The index is expected to enter an earnings recession with a third quarter blended growth rate of -8.4%, and fourth quarter estimate of -7.0%. The negative surprise on results through month-end also give us caution, as it indicates that expectations were too optimistic. Weaker-than-expected earnings combined with slowing economic growth, has led to material earnings revisions for fourth quarter, with nine of 11 sectors showing negative revisions. While the next-12-months P/E for the index has fallen to the lowest level since March, we believe earnings will decline further and thus, we remain cautious on the relative attractiveness of current valuations.
Emerging Markets
China stimulus hopes fail to offset real estate concerns
In October, the MSCI Emerging Markets (EM) IMI Index was the first of the major global indices to fall into a correction, led lower by cyclical stocks in Financials and Industrials. While most countries were down for the month, the best regional performers were Europe and South America, whereas Asia lagged.
With the exception of Real Estate, which was down 9% in October, equities in China outperformed the broad EM index, as investors reacted positively to reports of additional fiscal stimulus measures; specifically, 1 trillion yuan earmarked for the decade-old Belt and Road Initiative. While new infrastructure spending would be a welcome relief for the global economy, in our view, it is more likely to provide a longer-term impact than an immediate injection of stimulus.
China’s third quarter GDP grew 4.9% year over year, beating the consensus estimate of 4.5%. It also remains in line with the government’s 2023 target of approximately 5%. While retail sales and industrial production growth for the quarter also beat expectations and accelerated from the prior month, leading indicators such as manufacturing and services PMI data came in weaker than expected, and manufacturing survey data is already falling back into contraction territory (Figure 3).
Figure 3: Manufacturing PMI in China
Weak outlook supports likelihood of a mild recession
As of 10/31/2023. Source: Bloomberg, L.P.
View accessible version of this chart.
Overall, equities within Consumer Discretionary led the index lower for the month, largely driven by macro factors such as rising global interest rates and negative headline risk within the automobile industry.
For more information, please contact your PNC advisor.
Figure 1: Yield Curve Changes
Inverted yield curve is further complicated by a bear steepener (view image)
Date |
Change in 2 Year UST Yield |
Change in 10 Year UST Yield |
1/2023 |
4.20% |
3.51% |
3/2023 |
4.89% |
4.06% |
4/2023 |
4.03% |
3.47% |
5/2023 |
4.40% |
3.64% |
6/2023 |
4.90% |
3.84% |
7/2023 |
4.88% |
3.96% |
8/2023 |
4.86% |
4.11% |
9/2023 |
5.04% |
4.57% |
10/2023 |
5.00% |
4.83% |
As of 10/31/2023. Source: Bloomberg, L.P.
Figure 2: ECB Policy Rate vs. Eurozone Inflation (%, y/y)
ECB monetary policy back to a restrictive level not seen since 2007 (view image)
Date |
ECB Deposit Facility Rate |
Monetary Union Index of Consumer Prices (MUICP) |
2003 |
1.00 |
2.20 |
2005 |
1.00 |
2.10 |
2006 |
1.50 |
2.50 |
2008 |
2.75 |
2.1 |
2009 |
0.25 |
0.60 |
2011 |
0.75 |
2.7 |
2012 |
0.25 |
2.4 |
2014 |
-0.10 |
0.5 |
2015 |
-0.20 |
0,5 |
2017 |
-0.40 |
1.3 |
2018 |
-0.40 |
2 |
2020 |
-0.50 |
0.3 |
2021 |
-0.50 |
1.9 |
2023 |
4.00 |
2.9 |
As of 10/31/2023. Source: Bloomberg, L.P.
Figure 3: Manufacturing PMI in China
Weak outlook supports likelihood of a mild recession (view image)
Date |
China Manufacturing PMI (rolling 6 month average) |
10/2018 |
51.2 |
6/2019 |
49.7 |
2/2020 |
47.5 |
10/2020 |
51.1 |
6/2021 |
51.1 |
2/2022 |
49.9 |
10/2022 |
49.6 |
6/2023 |
50.3 |
10/2023 |
49.4 |
As of 10/31/2023. Source: Bloomberg, L.P.
