United States

Market rally loses steam as credit downgrades and higher interest rates weigh on markets

Domestic equities trimmed their year-to-date gains in August, with the S&P 500® delivering its first negative monthly return since February. Despite resilient economic growth and better-than-expected second quarter earnings, investor sentiment moderated as global growth concerns and expectations for higher-for-longer interest rates weighed on markets.

There were two notable downgrade events in August. First, Fitch Ratings downgraded the U.S. government credit rating one tier, from “AAA” to “AA+.” However, the U.S. Treasury market reaction was fairly muted. The second event caught many investors by surprise: both Moody’s Investors Service and S&P Global Ratings downgraded the outlook for several U.S. banks and issued outright rating downgrades for others. As lending standards have tightened substantially this year, bank loan growth is rapidly falling. We believe ongoing issues in lending markets could contribute to a mild recession in early 2024.

Federal Reserve (Fed) Chair Jerome Powell’s speech at the Jackson Hole Economic Policy Symposium on August 25 struck a hawkish tone and reinforced the Fed’s resolve to achieve price stability through restrictive monetary policy. Chair Powell upheld the possibility for additional rate increases and reiterated the path forward will remain “data-dependent.” He acknowledged that below-trend economic growth and softening in the labor market would likely be required to sustainably bring inflation back to the Fed’s 2% target. Despite this hawkish outlook, many investors largely believe the latest rate increase was the last one of the cycle.

Bond yields increased throughout the month. Yields tested their peaks from last October and hit a new high for the year before easing into month-end (Figure 1). 

Figure 1. 10-Year U.S. Treasury Yield
Bond yields rose on expectations for higher-for-longer monetary policy and a mild recession

As of  8/31/2023. Source: Bloomberg L.P.

View accessible version of this chart.

Higher interest rates and mixed economic data pressured equities across the market capitalization spectrum, with small- and mid-cap stocks leading the decline. These stocks had rallied over the past three months as optimism for a soft landing grew. However, softening economic data dampened investor sentiment, creating headwinds for these more cyclical investments.

The U.S. economy has remained remarkably resilient, largely due to the strength of the labor market. That said, we are noticing signs of moderation. The August payroll report indicated the highest unemployment rate since February 2022, and the June payroll report was revised lower to just 105,000 net new jobs, the lowest since December 2020. However, wage growth remains robust and, on an inflation-adjusted basis, has been positive for three consecutive months. In our view, wage growth strength challenges the normalization of inflation back to the Fed’s 2% target as it suggests consumers can withstand rising prices, which may enable certain components of inflation to remain sticky.

While economic activity has been supported by strong consumer data, manufacturing growth continues to slow. For example, the second quarter GDP growth rate was revised lower to 2.1% from the previous estimate of 2.4%, due to weaker than initially reported business investment. The monthly industrial production report also showed a negative growth rate for the third consecutive month, which has not happened since 2020. In contrast, July retail sales came in above expectations, rising 3.2% on a year-over-year basis, the strongest monthly growth rate since February. However, the leading category was services spending on restaurants, food and beverages, which may be elevated by food price inflation. We will continue to monitor rising credit; however, consumer debt service ratios remain well below concerning levels for now.

The July Consumer Price Index (CPI) reading rose from 3.0% to 3.2% as disinflation within food and goods was offset by higher energy prices. While headline inflation has declined significantly off its 9.1% peak, core CPI (excluding food and energy) remains elevated at 4.7% as services inflation and wage growth remain robust. Additionally, building permits, home sales, ISM® Manufacturing data and durable goods orders came in below consensus estimates. We believe the Fed will keep rates higher for longer until inflation reaches the 2% target and economic activity falls sustainably back to trend.

Second quarter earnings season for the S&P 500 proved better than feared. The blended earnings growth rate (consensus estimates combined with actual results) of -4.1% surpassed the consensus estimate of -6.8% just prior to the start of earnings season. However, the details indicate some glaring weaknesses. For example, removing Amazon.com, Inc.’s significant report, the growth rate falls to -5.9%, and upside surprise falls from 750 basis points (bps) to 690 bps. As such, just 44% of companies had a positive stock reaction the day of their earnings report, which is the lowest since the fourth quarter of 2020. Consensus still maintains an optimistic outlook on earnings, as revisions for third quarter and full-year 2023 have risen in recent weeks.

The Bloomberg US Aggregate Index contracted for a third consecutive month as investment grade yields increased. Notably, the Bloomberg US Treasury Index yield reached the highest level since 2007! Below-investment-grade credit continues to benefit from high interest rates as the Bloomberg US Corporate High Yield Index delivered a positive return. High yield credit spreads remain near the lowest level in over a year at 370 bps. We continue to believe as the credit cycle weakens and global economic growth slows, credit valuations look rich relative to core fixed income.

Developed International Markets

Rising risk of stagflation as earnings estimates remain lofty

Developed international equity returns were negative in August, effectively erasing the strong returns from July. Weaker-than-expected economic data in Europe and slowing growth in China continue to raise the probability of a global recession in 2024.

Despite increased volatility during the month, the Energy sector declined the least, as tightening oil market fundamentals supported prices. Japan remains a standout performer (in local currency terms), outperforming the S&P 500 by more than 500 bps. However, in dollars, the currency effect reverses Japan’s outperformance. The yen is nearly back to October 2022 levels, driven largely by the Bank of Japan’s ongoing decision to maintain ultra-loose monetary policy.

During the month, stagflation appeared to be taking hold of Europe’s economy despite modest growth in second quarter GDP projections. Elevated core inflation remains sticky, bank lending continues to weaken and services activity has converged with manufacturing. In fact, services and manufacturing are in contraction territory as indicated by their purchasing managers’ indices (PMIs). Furthermore, Germany’s second quarter GDP growth came in at 0%, marking a third consecutive quarter without positive economic growth. Leading indicators continue to point to a sluggish economy in Europe. Recession risk looms while corporate earnings remain lofty (Figure 2).

Figure 2. Eurozone PMI vs. 12-month Earnings Per Share Estimates
Analysts’ earnings expectations continue to diverge from leading economic indicators

As of 8/31/2023. Source: Bloomberg, L.P.

View accessible version of this chart.

The European Central Bank’s (ECB’s) data-dependent policy approach and single mandate of price stability is expected to be put to the test in September. Should inflation surprise to the upside, the ECB may be forced to overlook evidence of worsening economic growth and enact another rate hike. Consensus is mixed on the ECB’s predicted course of action. Based on futures market positioning, expectations for another rate hike currently hover around a 40% probability. In contrast, the Bank of England is expected to continue raising rates throughout the remainder of the year, as inflation reaccelerated in July. 

Emerging Markets

Investor confidence wanes as China's recovery falters

The MSCI Emerging Markets (EM) Index delivered a second consecutive month of positive returns — an achievement not seen in more than two years. The rally was led by equities in China, which outperformed the broader EM index on the hopes of governmental policy support for the real estate market and easing restrictions toward the largest internet-based companies.

Despite strong market returns, China’s recovery from the pandemic has increasingly shown signs of exhaustion. Quarterly real GDP growth declined from a pace of 2.2% in the first quarter, to 0.8% in the second quarter, confirming the fading rebound, and that the slowdown in domestic retail and the property sector has intensified (Figure 3).

Figure 3. China’s YTD Housing Activity, 2023 vs. 2019
Disjointed data points to real estate market weakness

As of  8/31/2023. Source: Bloomberg, L.P.

View accessible version of this chart.

Emerging market (EM) equities erased strong July gains. EM posted the weakest monthly performance since February as investors grew concerned about China’s economic outlook. The MSCI China Index was the worst performing major EM index for both the month and year-to-date periods but remains more than 30% above its October 2022 low. EM performance was led lower by weakness in China’s largest internet stocks as well as commodity-linked sectors such as Materials and Industrials, which fell in August on lower prices for every major industrial metal.

Many EMs are already experiencing manufacturing PMIs below 50 — a signal that activity is contracting. July’s economic data further confirmed China’s underwhelming rebound from pandemic lockdowns. The property sector, which represents close to 15% of China’s GDP (in contrast to low single digits for U.S. GDP), remains a key risk to growth. For example, housing starts and property sales year to date have widely diverged from housing completion rates, a sign of weakness in China’s real estate market (Figure 3). We believe the slowdown forming in China could contribute to a global economic slowdown in 2024.

For more information, please contact your PNC advisor.


Figure 1: 10-Year U.S. Treasury Yield
Bond yields rose on expectations for higher-for-longer monetary policy and a mild recession (view image)


10-Year U.S. Treasury Yields





















As of 8/31/2023. Source: Bloomberg L.P.

Figure 2: Eurozone PMI vs. 12-month Earnings Per Share Estimates
Analysts’ earnings expectations continue to diverge from leading economic indicators (view image)


MSCI Euro 12-months EPS estimates

Eurozone PMI composite




























As of 8/31/2023. Source: Bloomberg, L.P.

Figure 3: China’s YTD Housing Activity, 2023 vs. 2019
Disjointed data points to real estate market weakness (view image)

New Housing Stats


New Property Sales


Housing Fixed Assets Investment


Housing Completions


As of 8/31/2023. Source: Bloomberg, L.P.