Risk assets suffer a bond market beatdown

Market index returns

Month to date since August 31, 2023 as of September 30, 2023

Index definitions: Global Real Estate = FTSE EPRA/NAREIT Developed Index; Global Infrastructure = Dow Jones Brookfield Global Infrastructure Index; Natural Resource Equities = S&P Global Natural Resources Index; Commodity Futures = Bloomberg Commodity Index; TIPS = Barclays US TIPS Index; Global Equities = MSCI World Index; Real Assets Index = 30% FTSE EPRA/NAREIT Developed Index, 30% Dow Jones Brookfield Global Infrastructure Index; 15% S&P Global Natural Resources Index; 15% Bloomberg Commodity Index, 10% Barclays TIPS Index. Source: Bloomberg, DWS. Past performance is not indicative of future results. It is not possible to invest directly in an index.

Market commentary:

Global equity markets were mostly range-bound for the first half of September before turning decidedly south. Losses accelerated following the U.S. Federal Reserve (Fed) meeting where rates were held steady, but the forward dot plot suggested higher for longer, hence leaning hawkish, a recurring theme echoed by other central banks. The month culminated with higher long-term interest rates, a stronger U.S. dollar, surging crude oil prices (which have since retraced), and turmoil across labor markets as well as within the U.S. Congress. All of these factors contributed to rising equity market volatility and manifested in broad-based pressure across risk assets. Within Real Assets, Natural Resource Equities and Commodities held up best, buoyed by the rise in energy prices, along with TIPS. Global Infrastructure securities and Global Real Estate securities registered steeper losses as interest rate-sensitive segments were hit hard by the prospect of policy rates remaining elevated.

Why it matters: Heading into the final quarter of 2023, we expect equity market volatility could remain elevated as broader risks linger around labor strife, fiscal spending, and a leaderless House of Representatives in the U.S. Rate hikes from central banks appear to be coming to an end, but slowing global economic growth leaves the door open for a potential recession in early 2023. Finally, we would note that the more bond-like segments of equity markets (i.e. utilities) have been particularly hard hit as longer-term Treasury yields skyrocketed. Nonetheless, for hard hit sectors with fundamentally-positive intermediate-term outlooks, temporary weakness of this nature could present attractive buying opportunities. Overall, we maintain that an allocation to Liquid Real Assets can help investors with portfolio diversification, potentially obtaining some downside protection while maintaining (or even increasing) liquidity and offering attractive total return potential for the long run.

Digging deeper: First on the docket, we remind readers to check out our deep-dive commentary and performance dashboard for a detailed recap of September performance. Below, we turn to the more recent events of this week, including a review of fresh U.S. labor market data, how Europe is faring in its battle with inflation, and what economic activity indicators are telling us about the likelihood of a recession. Finally, we end with some observations on an about-face from the energy sector.

No signs of labor slack: This week, labor market data was back in focus. First up, the JOLTS report revealed that job openings in August swelled to 9.6M (up from 8.9M in July and far above estimates of 8.8M), signaling persistent labor market demand. This was supported by low weekly jobless claims of just 207k (lower than the 210k forecast and up just slightly from 205k the week prior). But the bombshell came in the form of an unexpectedly strong September Jobs Report from the U.S. Labor Department, which showed a +336k increase in jobs in September (versus expectations of roughly half that amount and +227k added in an upwardly revised August), representing an 8-month high. Slowing hour earnings and an unemployment rate of 3.8% vs expectations of 3.7% were the only marginally soft statistics in an otherwise firm labor report.
Better days for the ECB?: Last Friday, the latest Eurozone flash inflation figures were released, which should have the European Central Bank (ECB) in a festive fall mood. Inflation (on an annualized basis) abated to its lowest level in nearly 2 years, coming in at 4.3% for September (down from 5.2% in August), while core inflation also fell to 4.5% (down from 5.3% in August). Following its latest “dovish” rate hike to a record 4% in September, the ECB should take comfort from indications that inflation is responding positively and swiftly to rates that they’ve characterized as “sufficiently high”, particularly as growth expectations are bordering on morbid and deviations at the country level (hang in there Germany) complicate the committee’s work.
Service sector struggles: Economic activity indicators painted a somewhat less sanguine picture of the U.S. economy relative to the jobs report. We’ll start with the better news, which is that manufacturing activity (though still south of the 50 level, indicating contraction) ticked higher in September, with the S&P PMI clocking in at 49.8 (versus 48.9 the month prior) and ISM manufacturing at 49.0(up from 47.6 the month prior). The bad news is that stalwart services activity is showing further signs of strain, with ISM services down from 54.5 in August to 53.6 in September and the S&P U.S. Services PMI services flirting with contraction at 50.1. Elsewhere, Germany’s service sector also managed to stay in the black (50.3 versus expectations of 49.8). Still, the outlook remains cloudy; a sustained slowdown in the services sector could dent economic resilience and tip the scales toward a recession.
Demand destruction clobbers Crude: During September, the factors driving price action in the energy space were mainly of the supply-side variety, with voluntary cuts from Russia and Saudi Arabia proving particularly effective amidst tight inventories. While there was no change in posturing from everyone’s favorite oil cartel at the October 4th committee meeting (output cuts will continue), a swift economic hammer was brought down this week as investors fretted over global demand, particularly in the face of macro weakness and a stronger U.S. dollar. Sharp declines in Gasoline demand and an unwinding of long positions in Crude are loosening energy market dynamics with an immediate effect on prices – WTI Crude has fallen precipitously from $90.8/bbl to $82.7/bbl as we write on the afternoon of October 6th.

What we are watching: This week, we make some obligatory remarks about the state of affairs in Washington, which are aggravating unrest across global capital markets. We then consider more upward movement in bond yields and the possible implications for certain Real Assets classes. From there, it’s over to Japan for some good old-fashioned speculation in light of recent intervention by the central bank, before we wrap up with a preview of economic indicators due out next week.

Opening the flood-Gaetz: This week, a small group of Republicans succeeded in bringing down the House (of Representatives) by voting with Democrats to oust its speaker, Kevin McCarthy. The speaker’s removal (led by Representative Matt Gaetz of Florida) appears to be retribution for his reliance on Democratic votes to pass a stopgap spending bill to avoid a government shutdown. Markets reacted accordingly: U.S. Treasury yields reached their highest levels in over a decade on Tuesday while the S&P 500 dropped 1.4%, its lowest close since May. In the aftermath of Tuesday’s Congressional chaos, the future of House leadership is unclear. In the meantime, the governing body finds itself in the awkward position of being unable to pass any new legislation until a new speaker is chosen. With a fresh deadline for another shutdown looming a little over a month away, we will be watching developments closely; further political polarization could translate into heightened capital market volatility.
Will Gold hold?: Longer-term treasury yields continued their march higher this week; after ending September at 4.57%, the yield on the U.S. 10-year Treasury note surged another +20 bps to 4.77% on October 6th. As we noted last week, higher real rates appear to be the primary culprit as inflation breakevens have stabilized or trended lower. The most obvious casualty has been Gold (which sees its opportunity cost rise along with the yields of interest-bearing investments), the price of which went into free fall from above $1,900/oz before finding a new floor near the $1,800/oz level. Conditions would arguably be even worse were it not for central banks (particularly in China and other emerging markets) which have been gobbling up gold in an attempt to diversify away from the U.S. dollar, providing critical support. Whether or not Gold prices maintain support at current levels will be an important indicator.
Ninja moves out of Japan?: As if there weren’t enough going on this week, a spike in the Japanese yen, which surged to 150 per U.S. dollar before suspiciously stepping down, became the subject of intense speculation on Tuesday – could Japanese authorities have stealthily intervened in currency markets? Further analysis of money market data suggests probably not. However, the Bank of Japan (BoJ) was forced to make unscheduled 5-to-10-year bond purchases of ~675B yen on October 4th to maintain its yield curve control policy as bond yields headed towards the north end of the stated 1% cap. With recent commentary from an anonymous BoJ official setting up for a convenient exit from its ultra-dovish agenda, we will be carefully monitoring their shinobi techniques in the coming weeks.
A preview of key data and dialogues: Looking ahead, next week will bring us additional Fed- and ECB-speak along with the September minutes of the FOMC meeting and Monetary Policy Meeting Accounts from the ECB. Additionally, we’ll look forward to more insights on inflation as the Producer Price Index (PPI) and Consumer Price Index (CPI) data is due. Finally, we’ll be crossing our fingers as we get a preliminary glimpse of consumer sentiment and European industrial production on (of course) Friday the 13th. See you next week!

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