Best October Ever | Nasdaq

OWith all the pessimism of a looming recession, it seems the Dow’s October performance has slipped away from just about everyone. By the end of the month, the Dow was up almost 14%, ranking it as:

• Best October ever
• The best month since January 1976

Admittedly, this only applies to the Dow, which has only 30 stocks and is weighted by stock price, not market capitalization. Broader indexes like the S&P 500 and Nasdaq-100 did not see the same gains.

Chart 1: Monthly returns of the Dow Jones since 1900

Recent news has looked mostly negative, so what suddenly made traders so bullish?

A slowing economy makes it more likely that the Fed will not need to raise rates as much. And that’s good for stocks.

Rising interest rates are supposed to slow the economy and slow inflation

Since we started seeing bottlenecks in the supply chain, the costs and prices of some purchases have increased. This led to headline inflation rising above 8%.

Inflation is bad for the economy in many ways, but mostly by making things more expensive so consumers can’t afford to buy as much.

Economic theory suggests that one way to fight inflation is to raise interest rates. Higher interest rates encourage individuals and businesses to save or borrow and spend less. This reduces demand, which not only slows the economy, but also forces companies to cut prices to maintain sales, which reduces inflation.

Research shows that the theory works; however, it also works with a lag. In fact, on average, it can take nearly two years for rate hikes to have an impact on inflation (Chart 2A).

However, the same research suggests that the economy is slowing much faster in response to rate hikes, with industrial production beginning to fall about six months after the first rate hikes (Chart 2b).

Charts 2a & 2b: Rate hikes act with a long lag on inflation, but a shorter lag on activity

Already this year, the Fed has raised rates from just over 0% to almost 4%. According to the research, higher interest rates haven’t had much time to affect inflation yet.

The risk is that if rates rise too long or too high, you could cause economic activity to decline more sharply. It can turn into a recession, where corporate profits fall and unemployment rises, which is also not good for the economy.

It is therefore normal that the Fed finds that its new higher rates are already having an effect on the economy before reducing inflation.

This is important because too high interest rates – or the resulting recession – are both bad for stock market valuations.

Leading indicators point to a slowdown

There are signs that the economy is already slowing down.

The Conference Board’s Leading Economic Index tracks data that shows early trends in the economy. It tracks things like:

• Stock prices and bond rates, which show what market experts expect to happen in the future.
• Consumer expectations, which should guide consumer spending habits.
• New orders rather than completed sales.
• Weekly new unemployment claims rather than monthly unemployment rates.

This index (graph 3) has fallen into negative territory, which is generally only observed during a recession.

Chart 3: Leading economic indicators show a slowdown

US manufacturing data is also poised to contract (a PMI below 50 signifies contraction) as it fell from an unusually high peak (Chart 4, blue line).

Manufacturing was one of the first areas to benefit from Covid savings as housebound consumers spent their money on “stuff”. This led to supply chain bottlenecks that worsened import cost inflation, and product shortages contributed to margin expansion, all of which led to early readings. of inflation. Importantly, the slowdown in the manufacturing sector is also slowing goods inflation. The problem is that prices for services are now rising.

Other central banks with similar data have already started to slow their interest rate hikes. Recently, the Bank of Canada and the Reserve Bank of Australia opted for lower than expected rate hikes, and the European Central Bank (which only raised rates to 1.5%) also signaled lower increases ahead, although all still have high inflation. .

But US activity remains robust

However, in the US most other data still shows the economy to be “better than normal”.

More than offsetting the slowdown in manufacturing, the US services sector remains expansionary (well above 50, chart 4, green line), despite falling to post-Covid lows this week.

The strength of services matters because they represent 80% of the economy, so its strength actually affects the economy much more than the weakness of manufacturing. It also helps explain why the labor market is still tight, which keeps wages high.

Chart 4: Industry and services surveys show no contraction

Labor and inflation remain surprisingly strong

Demand for workers has also helped keep wages rising, supporting spending, which helps explain the stubbornly high and persistent inflation.

In reality, the Fed has a “dual mandate”: to keep inflation and unemployment low. Currently:

• Inflation remains stubbornly high, with core CPI growing at its highest level in 40 years, despite inventory replenishment and slowing manufacturing – inflation now runs through rents and sector wages services.

• Unemployment remains at its lowest level in 53 years, and despite some public layoffs in the tech sector, it shows no sign of abating, at 1.9 jobs per job seeker.

Charts 5a & 5b: inflation and unemployment remain surprisingly high

If the Fed only considers these measures, there are still plenty of reasons to hike, as low unemployment is likely contributing to inflation.

That’s why some fear the Fed is making a “policy mistake” and hiking even as other data shows the economy is already slowing.

Although Fed Chairman Powell said the Fed would likely opt for lower rate hikes going forward, he also said the peak rate could be higher than previously thought. In fact, the market now expects rates to peak above 5.1%. This is more than we expected in October, which is why markets, and growth stocks in particular, fell.

And corporate profits are holding up

Of course, strong employment and spending are also contributing to corporate earnings, which is good for stock prices.

So far, third quarter earnings are holding up, indicating that underlying consumption is still strong. Although profits in some sectors are currently under pressure, profits in the energy sector – thanks to the increase in oil and gas prices caused by the war in Ukraine – are helping to maintain market-wide profits. .

Markets may already be eyeing 2023

Putting it all together, there may now be enough data to show the Fed that the economy is starting to cool, and just like other countries, it will soon be time to stop obsessing over it. inflation.

Other data suggests that even with higher rates, things are not as bad as they seem for the consumer.

Either way, the current bear market may have already priced in a lot of the bad news. This year’s sale is already worse than average, beaten only by some of the most dramatic post-war economic collapses, including:

• Covid, which was the deepest recession
• The credit crisis, which was the longest
• The recessions of the 1970s, when rates had to exceed 10% to slow inflation, among much stronger demographics than today.

Chart 6: The last three market sell-offs have been among the worst in history

October benefited from bad news. This indicates that inflation and employment data will slow soon and central bank interest rates may rise less than expected. That, combined with underlying strength in employment and consumption, points to a weaker slowdown, which is good for equities.

At least, that’s what the data shows so far. Hopefully the Fed is watching it too.