Making Sense: October Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. I'm joined today by our Chief Investment Officer Brent Ciliano and Phil Neuhart, our Director of Market and Economic Research. Today is Wednesday, October 25, 2023, and I want to welcome you to our monthly Making Sense Market Update series.

Before I turn it over to Brent and Phil, I do have a couple of reminders for you. First, we received a number of questions from you all through our registration process, and we will answer as many as possible in today's discussion. If you have a specific question about your financial plan, please reach out to your First Citizens partner.

Lastly, as always, the information you're about to hear are the views of and opinions of the authors at the time of recording and should be considered for educational purposes only. Brent with that, we are ready to go, so I'll turn it over to you.

Brent: Great, Amy. Thank you so much, and good afternoon everyone. Hope you are well. Phil, it's almost Halloween. I know the fixed-income markets have been a little bit scary of late. Hopefully, we can demystify some of that for the audience.

Phil: Good job, good job.

Brent: Thank you. Thank you. So why don't we jump right in, Amy, and we're going to start with an economic update. And let's start on the growth front.

Expectations coming into this year, Phil, that was significant monetary policy was going to curtail growth. And you can see expectations—from the 1.9% that we saw in 2022—expectations, a significant contraction of 0.4.

The good news is that the US economy has been incredibly resilient. Labor market has been strong. Services spending has been strong. And we are now sitting at a point where growth expectations of today—2.1%. No contraction—actually expansion.

Atlanta Fed GDP now for the third quarter is looking at 5.4%, real GDP growth potentially for Q3. So an incredibly resilient market, right, a resilient economy. And interestingly, here we are in the fourth quarter, and it's sort of take two-expectations coming into 2024 are for again—growth to significantly slow to 1%. Time will certainly tell, and I think we're going to get into where we are from here.

So Amy, why don't we go ahead, and, you know, again, growth is in fact slowing. What we're looking at here, gold line is manufacturing. Gray line is services. And what you can see is—from the highest, Phil, that we saw back in 2021—both significantly slowing. The good news is is that for the last 3 months, when we look at the gold line, which is manufacturing, we've seen manufacturing go from 46.0—which was in contraction—up to 49.0, so 3 consecutive months of better prints than what we had in June.

Services, um, again, you know, got flirted with contractionary territory, but have been solidly in expansion. I know that we're going to be having prints here in the first week or so of November. Consensus expectations for both see a little bit of a pullback, but not much. Again, pretty resilient recovery that we're seeing right now in manufacturing, and services continues to be strong.

Phil: And services, of course, a large portion of our economy. So it being in expansion is why surprise to the upside in terms of GDP growth so far this year.

Brent: Yeah, and one of the reasons that we're seeing this economic, uh, growth slowing is the significant impact of, of monetary policy on the next slide, Amy. And you can see what we're looking at here, Phil, is every, uh, Fed policy hiking cycle, uh, since 1982. The gold line is this current cycle, and you can see it just jumps off the page on you—the most significant cycle that we've seen in more than 40 years as it relates to basis points of hikes and the compressed nature of this cycle. Right now, we're sitting at 5.25 to 5.50, so from a, you know, Fed funds expectations perspective, Phil, where do you think we're going?

Phil: Yeah, so if you look at Fed funds futures, they don't believe the Fed's own projections. They're going to hike once more year. So right now, 99% chance the Fed's on hold on the November 1st meeting. Looking to the December meeting, about a 30% chance of hikes, so 70% chance they hold.

Looking forward to next year, futures are currently pricing 325 basis-point hikes through the whole course the year. But that doesn't begin, you know, the earliest until maybe middle of the year.

So stepping back, the story is the Fed has tightened policy aggressively and is likely to remain at a fairly aggressive level for some amount of time. So why has the Fed been so aggressive? That's on the next slide. And it's inflation. Right? We show this slide every month. We'll probably keep showing it until we get closer to the Fed's target.

So as a reminder, consumer price index year on year peaked at 9.1% last June. That's the gold bar here, has fallen, is currently at 3.7%, but the Fed's target's 2%. So that's why the Fed's remaining aggressive. The unfortunate thing is core CPI, which excludes food and energy, and tends to irritate people because we all spend money on food and energy, but it's a measure of underlying inflation—we'll talk about another measure in a moment—um, it is even above the rate of headline inflation. It's currently at 4.1%. So the Fed is not going to take their foot off the pedal until we start to see that underlying inflation come down.

To that point, another popular measure of underlying inflation is called supercore. Unfortunate name, but it's core services less housing, so let's just exclude everything you actually spend money on. But it is something that's watched by the Fed. And, you know, sometimes you'll hear people say, the Fed only focuses on core or supercore—that's not true. They're looking at headline inflation as well.

Brent: They're looking at the labor market. They're looking at a myriad of things.

Phil: The idea that Fed's looking at one number is just not the case, but they do try to find measures of underlying inflation. The supercore that you can see here is still near 4%. So, again, we need to see that closer to where it was prior to the pandemic—at least sub 3%, I believe—before the Fed starts to feel comfortable.

Brent: Yep.

Phil: So what could get in the way in terms of headline inflation? Well, it's gasoline prices, right? We've seen a rise in recent months in gasoline prices. A little tick down recently as crude oil has come down a bit, but crude oil is elevated. Fortunately, gas prices have not gotten back to the 2022 post-Ukraine war level, but still high. So if you're thinking about risks to the outlook—retail gasoline prices and just the energy complex generally with geopolitical concerns in the Middle East, the war continuing between Russia and Ukraine. Obviously, energy is a risk. So let's talk about that outlook for which there are some risks on the next slide.

This is consensus inflation expectations going forward. You can see the gold bars here are fourth quarter and then into next year. You see expectations that inflation will continue to moderate, but it never gets to the 2% level.

Brent: That's right.

Phil: Right? And when we were updating this this month, some of these numbers actually ticked up a tenth, and so why is that? It's energy prices, that's why.

So inflation, the idea that inflation's sticky—and probably here to stay—is certainly something that we have to contend with. Now that said, if the Fed were to get inflation below 3% on a sustained level, they're probably pretty happy with that. But we still have a ways to go before we get there.

Brent: And it's a little bit of a conundrum, right, because, you know, the last 20 years—you've seen inflation running about 2%. Longer term, it's closer to 2.7%. So at the end of the day, will we get to a point where it's close enough to 2% or is that the, you know, line in the sand that we actually need to see? So, but again, I think that supports what we've been saying for quite a long time in these WebExes is that we're likely going to be higher for longer, and it's going to take some time for rates to really come back.

Phil: And to that point, Brent, we often get the question when we're on the road, is the Fed going to change its 2% price target? That is extremely unlikely. I say price target—Fed inflation target, I should say. That's extremely unlikely because that would communicate to the market—inflation, right? So they are very into what they're communicating to the marketplace. Does that mean inflation has to get to 2.0%? No. It's an indicator, just as if inflation's at 1.9%. Does that mean it has to get exactly to 2.0, but they need to get it lower than it is today, and they're going to keep their foot on the pedal.

Brent: So horseshoes and hand grenades is basically what you're saying that relates to Fed policy.

Phil: Exactly.

Brent: Excellent. So one of the things that has been sort of the bastion of resiliency, Phil, in our economy has squarely been the labor market. Right? So we saw just a blowout jobs report in October—336,000 jobs.

Phil: Upward revisions.

Brent: Upward revisions from 187,000. So we saw consensus expectations at 179,000, and we put up a print like 336,000. The unemployment rate's still sitting at a ridiculously low level of 3.8%.

You know, the 6-month moving average of 234,000 jobs remains remarkably resilient. And from a continuing claims perspective, a jobless claims perspective—still historically low. So the labor market, while we're seeing some signs of loosening around the fringes—we'll talk a little bit about the UAW strike and Kaiser Permanente and some other places where you might see some striking that might affect the labor market—but by and large, the labor market overall has been pretty resilient.

One of the signs of loosening on the next slide, Amy, that we've been talking about is job openings per unemployed persons. And you can see when we got to that high level in, you know, 2021 of almost two open jobs per unemployed person, was just massively, Phil, above the long-term average. We've seen that moderate lower. We're sitting now at about 1.44, you know, job openings per unemployed person—still massively above the long-term average.

Phil: Look at that versus history. And when we're on the road, Brent, you know, in my client conversations with business owners, this is the number one complaint—availability of labor—and there are certainly some structural challenges there as we can see, as we flip forward.

So a narrative we heard come out of the pandemic was, Americans just don't want to work now, right? There's just no participation. And by the way, there was very low participation for some time, but the truth is that that is no longer the story. So here we show participation rate on the left side of prime age workers—that's 25- to 54-year-olds. And on the right side, 55 and older. So what you'll see is prime-age workers.

Brent: So you're on the left, and I'm on the right. Is that is that how?

Phil: Yeah. Very close. Prime-age workers on the left side, as you can see, it's actually above the 2019 pre-pandemic level. So participation among the core workforce is actually better than it was before the pandemic. People are back to work.

The issue is—age 55 and older participation has fallen. Now, why is this? The baby boom is retiring. This is something we have known about since the 1950s. We have talked about for decades, right, in context of Social Security, Medicare, et cetera. Well, it's finally here. Now you could argue the pandemic accelerated, right, that retirement. You see that big tick down. I think that there's certainly people that are pulled into retirement earlier than they maybe originally planned, but you have a massive generation moving into retirement. That makes the labor force tight. So when we think about that previous slide—job openings per unemployed—this is not just cyclical. This is structural, and these are things we're going to be talking about for some time outside just the business cycle.

Brent: Yeah. And, you know, time will tell when you look at the slide on the right, is that going to, you know, is that, you know, post-pandemic situation going to continue? Is, you know, an economic downturn or decrease in savings or decrease in financial assets going to drive that number back up?

Phil: Or people pulled back into the labor market.

Brent: Right. And certainly from a demographic perspective when you look at the chart on the left, right? You know, the baby boomers, yes, are aging out. But we have seen from a population perspective—at least within the United States—that prime-age workforce, you know, sort of the 18- to 33-year-old, actually be much better than what expectations were some years ago. So time will certainly tell us—

Phil: Yeah, the benefit of what was called the echo boom for a long time, eventually called millennials. They're coming in, but you still have a large segment coming out.

Brent: Exactly.

Phil: So you have to replace that. If we flip ahead a big topic, of course—Brent, excuse me, alluded to it—is, um, union labor. So of course we have the UAW strike. We have strikes in Hollywood. Really, it's a pretty wide swath in terms of private unions. A statistic we point out—and you hear a lot of people speak to— is union workers' percentage of total private employment has fallen pretty precipitously down to 6%. We've seen a real structural shift there. But we—so one, let's say, UAW gets its full 40% pay raise, right? That's unlikely, but let's just say it.

The impact on wage data for the nation is not all that dramatic. But what we do think is what's happening with unions is what's actually been happening outside of union labor really since the pandemic, which is that there's a shortage of labor. Labor has more power now than they certainly have had for some time—you can really argue decades.

And to that point, as we flip ahead, that has supported wage inflation.

Brent: Yeah, and what we're looking at here when you think about average hourly earnings, right, I mean, you know, we've certainly seen a comedown in average hourly earnings from the highs that we saw, you know, kind of pandemic era, post-pandemic era. But again, sitting at 4.2%—40% above the 15-year average of 3%. So the good news is that people have jobs, their wages from almost every economic strata—low income, middle income, high income—have seen decent wage growth, and again, while it's trending down, still looking pretty robust relative to the long-term average.

So as long as people are employed, they're making a decent wage, we believe that they're going to continue to spend in a pretty significant way.

Phil: And you're in a situation where wage inflation exceeds price inflation, exceeds that CPI print—which was not the case last year. So that's a positive. It can have impact on company margins, though. We can talk about that in a moment. There are follow-on impacts, but still fairly good news for the consumer.

Brent: Yeah, and when we take it to consumer spending—which, you know, Phil, you and I have covered an awful lot, right? So when you think about the breakdown of US Real GDP. More than, you know, 68% is consumption, another 4.7-ish% is housing. About 72% is about the consumer.

So as goes the US consumer, as goes our economy, and what we're looking at here is the gold line is goods spending, and the gray line is services spending. Again, similar to what we saw with manufacturing and services earlier on—both are coming down from the highs that we saw in 2021. You can see goods spending at 2.9%—below the 20-year average, but it's ticked up a little bit, and we'll see where that goes as we get into the, you know, the holiday season and what happens with retailers. The good news is that, you know, more than three quarters of overall consumption and spending is services spending.

So spending on services at 7.4%—while trending down, modestly—lower than where we were last month. At the end of the day, services spending still materially above the 20-year average of, you know, 4.7%. So again, as consumers continue to spend, we’ve just seen a change in their spending habits from goods spending to services spending, which a good part of that is what's driving the economy.

Phil: And this data is supported by alternate sources like retail sales data that's been better than expected as well.

So let's shift gears a bit and talk about the housing market—something that comes up basically in every presentation we give. And it's a really interesting housing market, what is happening. Something that has played out differently than, say, 2008, you know, and other housing slowdowns. So let's just dig in for a moment.

One, on the left side—as you're all very well aware—mortgage rates have skyrocketed, right? We're hitting 8%-type levels, multi-decade highs there. Still looks low versus long-term history, but for most homebuyers—they aren't worried about what mortgage rates were 20, 30 years ago. They're thinking about where were they 12, 18 months ago. So, certainly, mortgage rates have gone up. What that has done is it has kept people who locked in low mortgage rates—through refinance or purchase—out of the market.

Brent: That's right.

Phil: Very hesitant to list your home if you have, say, a 3% mortgage. What it has driven is on the right side. Tight months' supply of homes. In other words, very tight inventory. Certainly, where we sit that's the case, and in most of the metro areas we go to, that is the case. So this a very strange dichotomy where you have high mortgage rates, which is actually driving limited supply. And that's driving some interesting things underneath the hood, on the next page here.

So housing starts on the left side, if there's no supply, well, how do you generate supply of homes? Well, you build new homes. So what's interesting is housing starts—they're down for their post-pandemic highs, but if you kind of draw a mental line across—where we are currently in terms of new construction is above the average 2019 level. Before, above the pre-pandemic, 2019 average level.

Why is that? We have to build homes because there's just no existing homes supply. On the right side, this existing home sales—that has plummeted. So if I just showed you mortgage rates going up in a straight line, existing home sales—because there's no supply falling dramatically—you would probably say home prices are in decline.

Brent: That's right.

Phil: Well, what's interesting is the next slide, which shows that's not the case because the supply is so tight, and that is the key indicator here. This is different than, say, 2008. It's supporting prices. So year-on-year price change in gold—slightly positive, touched zero for a little bit, but basically flat to up year on year across the nation. It'll be different in each geographic area.

Brent: But you have a base, and you're coming down such a high level.

Phil: That's right. And then look at the median sales price. Still up near peak. So home prices have actually hung in there, even as sales have plummeted. That is a good thing.

Brent: Yeah. So let's try and let's kind of bring this home, Phil, from an economic perspective. And let's talk about are we or are we not going to have a recession over the next 12 months? And, you know, again, as we've said many times, you could probably very easily get me to convince you that we aren't going to have a recession—and potentially a soft landing—and just as easily talk you into saying, Hey, there's a lot of things that would say maybe we will have a recession over the next 12 months. So I'm going to take the glass half full and allow you to take the glass half empty. Let's talk about avoiding the recession.

We talked about it for the last X number of webinars. We've had an incredibly resilient labor market. The US consumer is in great shape. And when you think about their wage growth, when you think about the jobs that have been created, when I think about something as far as, you know, consumer balance sheets like, you know, debt payments as a percentage of disposable income still sitting at very low levels. Overall, the US consumer is doing incredibly well. And again, they are spending on services, right? So the service economy is still doing incredibly well.

And as you pointed out very nicely—that's more than three quarters of our consumption. Right? So when you think about that, you know, the US consumer and the service economy is doing really well. As we just alluded to, residential construction a lot more resilient than maybe we would have expected given the circumstances with monetary policy actions. By and large, you know, while things have maybe slowed down just a little bit from the breakneck pace of price growth and appreciation that we've seen over the last X number of quarters, residential construction and residential real estate still doing pretty good.

Phil: And look, we've recently heard from homebuilder sentiment that has fallen. So it's something to watch. Homebuilders are getting more cautious again, but certainly a positive.

Brent: We're not looking at a 2008-type scenario.

Phil: That's right. And the recessionary scenario—what could push us there? Well, one, tighter monetary policy. I won't dwell on that for long—we spend a lot of time—the Fed is tightening policy, interest rates are up. Tighter financial conditions. If you look at things like loan officer surveys, banks have tightened financial conditions. That, of course, is equivalent to some number of Fed hikes, and then that tightens up the economy.

Brent: And just think about where—we're going to talk about it in a moment when we get to the market section—where have yields gone, right? Significantly higher, which is, you know, the equivalent of at least another hike as it relates to rates going up.

Phil: And Fed officials have pointed to the idea that the market's doing some of the work for them. Manufacturing economy, as we covered, has been slowing. We have an inverted yield curve. So for those who are interested, that means short rates are above long rates. That tends to predict recession.

We've been inverted for some time—has not happened yet. And then commercial property market. Unlike the residential property market, commercial property is seeing price declines. Nationally, if you look at the Green Street CRE Price Index, across a wide swath of commercial real estate, prices are down about 16% from their high this cycle.

Clearly this is a known risk. If you read much financial news, this is talked a lot about in terms of urban office et cetera, but a material risk and something that I think the market's going to be contending with for quarters to come.

Brent: Yeah. So let's shift gears, Amy, from the economy, and let's talk about markets.

So let's look at the graph on the left, and what we can see as we break this down between equities and fixed income. When we look at the bars on the left, obviously, Phil, you know, the light blue bar, you know, Q3 was certainly a down quarter for everything—whether it was US equities, international equities, fixed income—all down about that same 3-ish%.

So it was a rough quarter for financial assets et al. So when you think about where we are today from a year-to-date perspective, US equity markets up about 11%. Developed international markets are up about 3.5% through last night, the 24th. Emerging market equity has turned negative for the year by about a little bit more than 1%. But on the fixed-income side of the equation, we continue to see, again, third year in a row of losses for fixed income. The US Aggregate Bond Index down more than 2%. Municipal bonds down more than 2%.

So, again, um, good bit of volatility that we've seen in both equity and fixed-income markets. The chart on the right—when I sort of break down US equity markets, it has been all about tech and mega-cap growth stocks. You can see almost everything except for, you know, large- and mid-cap growth. I mean, certainly, you know, what's driving that, you know, large-cap blend obviously are the growth names within that category.

By and large, again, the magnificent seven continue to drive markets. We're in the heat of earnings weeks. So, you know, we'll have to see how big tech does as we get through third quarter earnings. But again, a very, very narrow market this year.

So when we get a little bit more under the hood on the S&P 500—again, so far year to date, what you can see is that we've only had, it sounds funny, two 8% drawdowns. Again, we're in—you know, we're still kind of in one right now. Relative to history, when I look at, you know, the S&P 500 calendar years going back, you know, post-1990, right? The average intra-year drawdown, Phil, is about negative 15%. So while it never feels good to see the equity markets down like we've seen post-July of this year, it’s barely more than a half of the average intra-year drawdown.

The good news is that when you look at where we are from the October 12th of 2022 lows, we're still about 19-ish% above the lows that we saw back in October of 2022. So again, normal volatility, I would say. And again, one of the questions that I know that you and I are getting an awful lot on the road from clients is—where do we actually go from here in this fourth quarter? So on the next slide, Amy, what we put together here is—we're looking at, you know, periods of time post-1960 where the January to July period saw a 10% or greater S&P 500 rally. What happened in August and September? And then what happened in the fourth quarter?

And when you run your eyes down the page, and again, we're only looking at six historical observations, excluding where we are right now. But you see a very consistent trend here, Phil, that the August to September has seen a negative environment for the S&P 500. But 100% of observations in the fourth quarter of those years where we saw that great start January to July—the S&P 500 was positive in the fourth quarter.

So let's knock on wood and throw salt over our shoulder that this year ends up like the historical trend post-1960. And we see a positive fourth quarter—about flat for October, and we'll have to see how the rest of the year plays out.

Phil: Absolutely. So let's shift gears to geopolitical concerns. Obviously, the Israel-Hamas war and the war in Ukraine continue as well. So we often get the question—what is the implication for risk markets, for the stock market? So here we're showing—including World War 2 forward—a number of geopolitical events, as you can see. We're just going to focus—there's a lot of numbers there, I know—let's just focus on the bottom—the median and the average.

So on average, you know, how long is the impact? What's the time to the bottom? Well, the truth is it's pretty short. 17, 16 days—median and average. We're talking about a few weeks of trading. The time to recover on median tends to be very quick as well—16 days. And as you look to the right—whether you're looking 1 week, 1 month, 3, 6 months, 12 months out—the market tends to actually, on average, perform pretty well from those lows driven by geopolitical events. So eventually, the market turns to fundamentals. Things like corporate earnings.

So geopolitical events are terrible, pull on the heartstrings. Eventually, the market moves past that to what is really going on in the business cycle, corporate earnings, et cetera.

So let's talk about corporate earnings. We're in the middle of an earnings season. Um, we're starting to make some progress—still somewhat early, a number of big names yet to report. 75% of companies—over 75%—are beating earnings expectations, but there have been some notable disappointments.

We certainly can't ignore that, so the market's been pretty choppy during this earnings season so far. So what are we looking for earnings this year and next? 2023—the estimate is 0.7% earnings growth, fairly flat. Um, not negative, I should point out. An up year in terms of earnings, but a weak year to say the least in terms of earnings growth.

Looking to next year, consensus is pretty optimistic—12.2% earnings growth. I'll take the under.

Brent: I was just gonna say, as analysts start to sharpen their pencils—that number is likely to come down.

Phil: Yeah, likely to come down, but let's say it comes down even fairly materially. Earnings growth is expected next year. Does not mean analysts are right, and then you can—just point of reference—7.6% average earnings growth.

One thing that is positive is on the right side. We are seeing margin expectations—profit margin expectations—start to tick up. Something we talked about a lot last year and coming to this year was the margins at those extremely high levels—look at how high we were—were not sustainable. They've started to come down, but now—or they did come down—now they're starting to pick up. That, when you think about why is the US stock market up this year? Well, a lot of it has to do with margin expectations improving—particularly among the magnificent seven, tech, et cetera. So that is driving optimism in the market.

Brent: And at least from an analyst expectation perspective, potentially, maybe we're through the worst of, you know, corporate earnings and some of the choppiness that we've seen there, and potentially the path forward is higher.

Phil: That's right. According to estimates, the low quarter has already passed, and we're now marching higher, which would be a good thing.

So in terms of our expectations around the stock market, I won't spend too much time because we're not changing our price target today. This is 12-month price target—4,650 on the base case. That's above about 10% from today, you know, even after the sell down—10% from Friday the 20th, I should say. That's, of course, includes the recent sell down.

Bear case, 3,600—down about 15%. Bull case, 5,330—up 26%. That is—that's goldilocks—that's the scenario in which we avoid recession, we have a soft landing and a lot of these issues sort of resolve themselves.

Brent: Yeah, and I think one of the things to point out—especially when you look at the bear case—again, you know, above, you know, the 3,577 that we saw in October 12th of 2022. So, you know, knock on wood. Potentially, you know, the lows might be in for the S&P 500.

So let's shift gears a little bit away from equity markets, and let's talk about fixed-income markets where we've truly seen a lot of fireworks, a lot of movements. And what we're looking at here is the US treasury yield curve. The gray line is where we were at the beginning of this year, and the gold line is basically where we are now.

And you can see significant, you know, more than a parallel shift. We've seen not only a parallel move—specifically when we look at sort of, you know, the belly in, so in essence, you know, intermediate to shorter rates—basically, I had seen a parallel move. As we go out longer beyond that belly—10 years and out—we've seen a little bit of a twist where we've seen somewhat of a bear steepener, where you have long rates moving up and short end is anchored in the line and starts to move up.

Significant movements, especially if you were to anchor your eyes, Phil, on the 10-year treasury yield—jeez, some, you know, couple weeks ago, we were sitting at, you know, 4.5, 4.6%. We've seen a, you know, 30 to 40 basis-point move in weeks, which is something that you would expect to see in many quarters—not in weeks, so significant—

Phil: And why was that move? The truth is the market is coming to terms with the fact that the Fed was not going to start cutting quickly. And you can see that through Fed funds futures, other market pricing.

Well, if the Fed's not cutting as quickly, that means longer rates are going to have a longer period with high Fed in that 10-year period, so that means 10-year needs to go up. So that's really what's pushed rates higher is expectations around the Fed.

Brent: That's right. So, why don't we take a look at a handful of fixed-income sectors on the next slide. And to sort of call out—and we've used this chart quite often—where we were at the beginning of 2022 to now is stark. Right?

And run your eyes down that list—whether I'm looking at the treasury market, whether I'm looking at the US Aggregate Bond Index. I mean, you went from 1.75, Phil, to almost 5.7% with a duration of almost 6.2 years. And when you continue to run your eyes down, look at something like US municipal bonds at 4.48, and in, you know, the 35% tax bracket—you're pushing almost 7% tax-equivalent yield. And again, look at something like high yield corporate bonds—almost 9.5% from a little bit over 4%, so across the board. While yields go up and bond prices go down, and that's never good, right, because usually people think about fixed income broadly as ballast in the portfolio. From a forward-expected-returns standpoint when we look at where yields are today, while it's painful in the short term, expectations going forward for various fixed-income sectors look quite thoughtful and might present a great opportunity for diversification in investors' portfolios.

So a question that we get asked an awful lot, Phil, is where's the 10-year yield going? We've had this incredible move over the last handful of weeks from about 3.5, 3.6%. We hit 4.99 here this month, right? Almost hit 5%. What we're looking at here is the gold line is the upper bound of Fed funds, and we're looking at every cycle post-1990. And the gray line is the 10-year treasury bond yield. And what you can see is that 100% of observations, except for this time, right, the 10-year yield has been at or above the terminal value of Fed funds in every cycle post-1990. And you can see where we are right now. We've gotten close to 5%. The upper bound of Fed funds is 5.50.

Will we see continued upward moves in the 10-year treasury yield? Time will certainly tell, but again, if it rhymes with history, we can see a little bit of short-term pressure on treasury yields until we get to a point where the Fed has leveled out, and then, you know, stays higher for longer, but you might see some continued volatility in the treasury market as we go forward.

Phil: So, yeah, so a question we often get is, well, if cash is paying me more than longer-term fixed income, why would I buy longer-term fixed income?

Brent: Yeah, I'm not going to buy duration.

Phil: And the answer is twofold. First, you know—as you already showed—eventually the Fed starts cutting rates, and those yields are higher in longer duration. You've locked in yield, right? But also there's the total return question.

Um, so here we did this analysis a few months ago. If you look at past hiking cycles—all the way back to 1989—what is the 3-year return following the final Federal Reserve interest rate hike? So we're looking at cash and gold—this is total return, we used the 3-month treasury as a cash proxy—and US Aggregate Bond Index. That's just broad fixed income. What you'll notice is the return for the Aggregate Bond Index is far exceeds cash. The reason is eventually rates fall, prices go up and you locked in that yield while cash is—once rates fall—not paying nearly as much.

So there is opportunity in fixed income for longer-term investors. Again, there's a reason we are not showing this chart for 6 months.

Brent: That's right.

Phil: For 9 months or 12 months. This is for longer-term investors. There is opportunity.

Brent: Well, and I think, you know, to be clear what—we're not, we're not picking which child we like, we like better here.

Phil: That's right.

Brent: At the end of the day—from a financial planning perspective—you know, having cash as it relates to ballast and your financial plan and liabilities that might be shorter term in nature, is absolutely important to have, and you're actually getting paid now for that cash.

But having that diversification in your portfolio between short-term reserves, as well as sort of that core ballast in your portfolio—whether that's, you know, taxable bonds or municipal bonds—having that balance absolutely makes sense. And we think again, forward expected returns for fixed income—while we've seen volatility—are quite attractive.

Amy: Brent, Phil, thank you so much for that deep analysis in the bond and equity markets, as well as the overall economy.

Just a reminder for all of those who may be interested in staying informed throughout the month, we have several publications available, including an economic outlook from Phil in our In Brief series that's delivered at the beginning of every single week.

Also, we will have an update next week on the Federal Reserve after that meeting and other information throughout the month for you to keep up to date on.

If you're not already subscribed, you can use the QR code on the screen to get signed up, or if you're using your phone to listen to this discussion, be sure to visit firstcitizens.com/wealth to get signed up. Brent, Phil, let's jump into questions. We had several come in this month.

Phil, I think this first one might be best for you. We talked a lot about the bond market and the value of yields, but what's the value in buying bonds at a higher yield if the positions are just going to get called once rates start to come down?

Phil: Yeah. It's a great question, and it's the reason we emphasize yield to worst when we work with clients. Yield to worst includes that callable nature of a given bond. Also, treasuries are not callable. Large portions of corpus are not necessarily callable. So it is about that yield to worst we're showing here, which generally—if you look through history—generally is a good indicator for a return over the duration of that fixed income because that call option does exist.

Brent: Yeah, and we've had across the board—we've had continued duration extension, which basically means if I think about where, let's say, the aggregate bond was, you know, 20 years ago, right, the duration was more with a three handle—3.7, 3.8, 3.9 years.

We are now seeing the Aggregate Bond Index at 6.1, 6.2, 6.3 years. So in addition to higher would say purchase yield or yield to worst, the duration period in which that hopefully would apply to is much longer than where we've been in the past. So it's sort of a two-for as you think about how long you might be able to see, you know, that type of yield environment.

Amy: Phil, will we ever see mortgage rates come down? I think we get this question every single month.

Phil: Yeah. Yeah, it's a good question. Look, mortgage rates are very highly correlated with longer-term treasuries. So think 10-, 20-, 30-year treasuries. So the real question is—do we see treasury yields come down?

And the answer is probably not in the near term. Here we're showing mortgage rates. If we flip over to slide 30, Amy, as Brent mentioned, generally, you see the 10-year stay somewhat near the Fed funds rate until it's pretty clear the Fed is going to start cutting.

So, look, what could bring treasury yields down? A surprise contraction in the economy, um, financial concerns, a flight to safety could breach treasury yields down, but outside of that, as long as the Fed has their foot on the gas, there's reasons to think that treasuries—they'll move around, they can go up, they can go down—will be somewhat elevated and that feeds directly to mortgage rates. Mortgage rates do not operate in a vacuum. They are very correlated to market rates, particularly treasuries.

Amy: Brent, maybe the only thing scarier than recent volatility is the gridlock in Congress. What are your thoughts around the consensus around the House speaker and the looming debt ceiling issue—and the potential for a government shutdown.

Brent: Yeah, it seems that there is never a lack of turmoil in Washington, DC, of late—certainly lack of consensus. And I think the one thing maybe that we could add to death and taxes as being a certainty maybe is, is geopolitical noise. What I think is really important is the slide that Phil covered, Amy, is that whether the geopolitical noise is a, you know, war, a pandemic, turmoil in government, they tend to be at least from an equity market perspective—transitory.

And equity markets tend to look through these geopolitical events and sort of then congregate towards what you highlighted, Phil, nicely, which is fundamental valuations. And as we talked about with corporate earnings and profitability, you know, it looks like we—knock on wood—we’re through the worst as it relates to corporate earnings, and maybe the directional path is slow but up as it relates to earnings and margins.

So, again, while we see some discord in Washington, DC, and some turmoil, the likelihood that that would materially feed back into equity markets—at least from an historical standpoint—is a low one, Amy. I think the equity markets are quite aware that government is quite turbulent and potentially dysfunctional from time to time.

Amy: Brent, speaking of volatility and the equity and the bond markets in recent months, what are your thoughts as we move towards the end of the year?

Brent: Yeah. And, again, Phil and I get this question probably now about five to six times a day, which is sort of why we put together—thank you, Amy—this nice slide is, again, history doesn't always repeat itself, but sometimes it rhymes. And we've had such an exceptional move from January to July, which again, think about it, coming into the year, we were positive on equity markets, not nearly as much as what we saw from January to July.

You and I did not predict 19.5% up in the S&P 500 from January to July. That's what occurred. It was a very narrow rally, but when you look at the six other historical observations, Amy, where we had a 10% or greater move from January to July, the August and September volatility has been historically normal.

So what we've seen from the end of July to the end of September—that negative 6.3%—again, is right in line with historical observations. The $64,000 question is, what will the returns for the S&P 500 be in this fourth quarter? Historically, we've seen it been positive. Again, fundamentals are starting to look a little bit better. With the sell off, valuations have been a little bit more attractive on a forward PE basis. We're starting to see earnings come around. We'll have to wait and see what the fourth quarter looks like.

But again, if history were to repeat itself, you would likely see a positive fourth quarter for the S&P 500.

Amy: Well, Brent, Phil, thank you so much for sharing your thoughts and answering questions. On behalf of all of us here First Citizens, I want to thank you for trusting us to bring you this information. That's something that we never take for granted.

We will be back again next month with another in-depth look at markets and the economy, and we'll be sending out information on how to get signed up in the coming days. In the meantime, we hope you have a great rest of the week, and we will see you back here in November.

Making Sense In Brief Outro Slide

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