Equities driven by opposing forces

Markets remained volatile over the past week, driven by the waxing and waning of investor optimism about an earlier-than-expected pivot in Federal Reserve policy. These opposing forces meant that a sharp rally in the S&P 500 faded fast, leaving the index just 1.5% higher on the week.

At the start of the week, US equities advanced 5.7% in two days and 10-year Treasury yields fell 24bps as a weak ISM manufacturing reading for September and a fall of more than 1mn in JOLTS job openings in August offered evidence of a slowing economy and loosening labor market. This raised hopes that the Fed could soon shift away from its hawkish stance.

However, Fed officials were quick to push back against this view. Chicago Fed President Charles Evans said on Thursday that the benchmark rate will probably be at 4.5% to 4.75% by next spring, while the Minneapolis Fed’s Neel Kashkari said the central bank is “quite a ways away” from pausing its campaign of rate increases. Further data releases pointed to continued robust activity: The ISM non-manufacturing PMI edged lower to 56.7 in September from 56.9 in August, ahead of expectations for a reading of 56.

On Friday, the nonfarm payrolls report for September reinforced the perception of continued strength in the labor market, underlining the case for the Fed to continue tightening policy aggressively. The S&P 500 fell 2.8% on the day. Ten-year Treasury yields ended 8bps higher on the week, at 3.88%.

There were some early signs of cooling in the US labor market report. The net rate of job creation at 263,000 for the month represents the slowest pace of jobs growth since April 2021. In addition, average hourly earnings showed a modest gain of 10 cents per hour in September after 9 cents in August. If sustained, this pace of wage growth would be compatible with the Fed’s 2% inflation target, in our view.

But the decline in the unemployment rate from 3.7% to 3.5%—matching its pre-pandemic level at a 50-year low—suggests that the labor market remains tight. Moreover, the labor force participation rate, which had risen in the prior month, edged lower to 62.3%. While it is important not to read too much into one month’s data, this could indicate that the US is running short of people on the sidelines who can rejoin the labor market.

The debate within central banks about the right pace of rate hikes is likely to intensify over the next few months. We expect this to drive more of the volatility that investors have dealt with over the past few months, with periodic rallies followed by pullbacks. We think a more sustained rally in equities would likely require indications of a clear downtrend in US inflation, along with signs of a cooling labor market, which could then allow the Fed to pause its rate hiking cycle.

We continue to expect another 75-basis-point rate hike from the Fed in November. The US consumer price index for September will be the key data release this week.

How do we invest?

With uncertainty set to remain high in the months ahead, we recommend building portfolios that can prove resilient across a range of potential scenarios.

• We tilt our preferences toward more defensive areas of each asset class, including consumer staples and healthcare stocks, and high-quality bonds. Our preferred currencies include the US dollar and the Swiss franc, two traditional safe havens that are also exposed to convincing rate-hike cycles.
• We also like global value stocks, the energy sector—which should be supported by higher oil prices in the quarters ahead—and the value-oriented UK market. The MSCI All Country World Value index outperformed its growth equivalent by 12 percentage points in the first three quarters of the year, and with inflation still well above central banks’ targets, we expect this trend to continue.
• With equities and bonds driven by expectations around inflation and central bank policy, we also recommend that investors seek uncorrelated sources of return, for example through diversification into hedge funds, particularly macro strategies, and private markets.

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