The weekender: Valuations and potholes extern

Markets

US stocks traded marginally lower Friday despite the well-behaved 'supercore' inflation print, which rose just 1.7% annually in August, or 3.4% over the last three months. However, investors continue to struggle amid a higher-for-longer rate environment weighing on previously stretched valuations.

We kick off October in what is typically associated with jockeying for positions ahead of the September payroll report. But if the federal government shuts down, many data releases will be shut down, too. However, we should still get surveys from non-government entities like the ISM or the University of Michigan. But the payroll report is the purview of the Bureau of Labor Statistics -- a federal agency.

It’s been an unfortunate period for investors as the S&P 500 rang in its first negative quarter of 2023, while its tech-heavy cousin, The Nasdaq Composite, wobbled on its way to a 4% drop in the quarter, the first since the final three months of 2022.

The shoulder-shrug reaction from stock investors to a Fed-friendly PCE print suggests valuations matter. Beyond the interaction between growth, inflation, and rates lies the mathematical impact of higher rates on risk asset valuation. Remember the dividend discount model: P = D/[r-g]. A bigger 'r' means a bigger denominator -- not good for the price of stocks, particularly those (like Tech stocks) where the cash flows are tilted towards the future, and the discount rate on those cash flows, consequently, has a more significant impact. The fact is that 10-year yields are soaring, and in the modern-day playbook for stock market operators, that is bad news on multiple levels.

China markets

The good news is that China’s economic data continues to stabilize; the bad news is that the property sector is expected to worsen.

The crisis in China's property sector continues to unfold, impacting the country's economy and global financial markets. While the situation is very problematic, it's important to note that the full extent of the crisis may not have been realized yet, and its effects are still unfolding. This crisis has prompted global investors to withdraw funds from China's stock market, contributing to market volatility and uncertainty. The property sector remains a crucial area of focus for policymakers and investors as they navigate these challenges.

But on a positive note, The National Bureau of Statistics (NBS) in China reported an increase in both the manufacturing and non-manufacturing Purchasing Managers' Index (PMI) in September.

For manufacturing

The PMI rose to 50.2 in September from 49.7 in August.

The output sub-index showed the most significant increase.

The new orders sub-index also increased.

For non-manufacturing:

The PMI increased to 51.7 in September from 51.0 in August.

This improvement was seen in both the service PMI and the construction PMI.

These PMI increases indicate positive momentum in both the manufacturing and non-manufacturing sectors in China for September. However, it's important to interpret these figures in the context of the broader economic situation in China, including challenges in the property sector and ongoing efforts by Chinese authorities to manage economic risks and promote stability.

Rates market

As interest rates transition to a "higher for longer" regime, two common questions arise: how much further can the current selloff extend, and what is the likely "center point" of the new range? Providing a definitive answer regarding the former is challenging, but yields will continue rising until some adverse effects or external events intervene. The increase in supply is a contributing factor, and there may still be room for yields to rise further, given that a significant portion of the supply increases is yet to come.

The initial phase of the repricing in bond yields seemed to be driven by growing optimism about economic growth. However, the more recent phase appears to be a consequence of the Fed Hawks and the US bond markets exporting the adjustment in its longer maturity rates to other countries, effectively pushing global bond yields into a "higher for longer" regime.

Forex markets

The recent strengthening of the US dollar has raised concerns about its impact on global financial conditions. While the Dollar may appear stretched, and potential US growth challenges could be ahead, several factors support its strength. These include:

US Resilience to Rising Yields: The US economy has shown resilience to the recent rise in yields, making the Federal Reserve's job easier in managing monetary policy. In contrast, Europe and Asia are more sensitive to yield changes, and policymakers are trying to ease their monetary policies.

Euro Area Concerns: Euro area growth is stagnating, and concerns about credit conditions are re-emerging, as seen in the BTP-Bund spread widening. The European Central Bank's ability to implement more restrictive policies is diminishing.

Chinese Yuan (CNY) Stability: The recent strengthening of the US Dollar has occurred despite a relatively stable Chinese Yuan (CNY). However, this stability may have its limits. The Chinese Yuan's real trade-weighted index (TWI) has appreciated by approximately 4% from its summer lows, even as Chinese officials have attempted to ease their policy stance. When the Dollar is this dominant across the board, the PBoC may have to remove some ballast and let it sink a bit more. Which in turn could promote additional broader dollar strength.

US Growth Pothole: While there might be a slowdown in US growth, it's not necessarily a clear negative for the Dollar if it doesn't signal a more severe downturn. Lower US growth expectations could temporarily weigh on the Dollar, but this may not be a stable path for long-term Dollar weakness.

In summary, the Dollar is expected to maintain its strength for some time. Still, some risks could lead to further appreciation, including Euro area concerns, changes in Chinese currency policy, and how markets interpret US growth prospects. But as always, when the US dollar positioning is stretched, FX markets are subject to data-driven and random walk two-way risks.

Oil markets

Both benchmarks are consolidating at lower levels after an explosive multi-week rally. Oil traders are growing concerned about US-specific factors like student loan repayments, ongoing UAW strikes, and the potential for an extended government shutdown( Economic Potholes). These factors could manifest as weaknesses at the gas pump. RBOB futures have already been feeling the pinch as the peak summer demand season ends

The effects of higher interest rates are also showing up. The University of Michigan's bimonthly consumer survey reported a modest slip in consumer sentiment in the United States for September. This decline in sentiment, coupled with several economic potholes lying in wait, has finally added an element of two-way risk in oil markets.

The rethink

The outlook for US economic growth in the coming months is being impacted by several headwinds expected to slow GDP growth from its previous pace of over 3% in the third quarter of 2023 to below 1%. These factors include ongoing strikes by the United Auto Workers (UAW), the resumption of student loan payments, the potential for a government shutdown, higher interest rates, and elevated oil prices.

There is a risk that, given the recent spikes in oil prices and interest rates, the market could interpret slower growth in the fourth quarter as a precursor to a deeper economic downturn, raising concerns about a recession. However, this scenario could lead to a dance between growth and rates where initial policy shocks evolve into growth shocks, followed by policy relief and, ultimately, a recovery in growth.

The good news is that both interest rates and oil prices seem to be approaching peak levels, particularly if economic growth slows. As these critical headwinds subside, equities are expected to find support. Still, certain market areas, such as small-cap stocks and regional banks, may continue to underperform, with long-duration growth stocks potentially leading any market rally.

The modern-day history book says that when rates move lower, it is generally bullish for mega-cap tech Stocks.