October 11, 2022 | macro-economic research report

Research Report: September Swoon

BY: Richard Croft
Let’s take a collective deep breath. September, which historically is the worst month for stocks, has passed – and it did not disappoint! We saw 10% declines in U.S. markets, while Canadian stocks, buoyed by energy and basic materials, lost less than half that amount.



Let’s take a collective deep breath. September, which historically is the worst month for stocks, has passed – and it did not disappoint! We saw 10% declines in U.S. markets, while Canadian stocks, buoyed by energy and basic materials, lost less than half that amount.

As the page turned from September to October, as if on cue, stocks surged out of the gate. It was an impressive two-day rally that added more than five percentage points to the broader U.S. indices. While we cannot discount a rally of that magnitude, it was, by all measures, event driven.

Investor spirits were buoyed when the Bank of England backstopped British bonds as the Pound Sterling was collapsing in response to Prime Minister Liz Truss’s proposed tax cuts. Without the BoE intervention, British pension plans would have faced massive margin calls. Apparently, everyone but Ms. Truss recognized the unintended consequences of lowering taxes on corporations and the wealthiest British citizens. Not to mention the inflationary impact of such actions.

Then there was angst that Credit Suisse, the world’s 41st largest bank, might succumb to a Lehman type collapse, as higher interest rates were squeezing the bank’s inventory of credit default swaps. It didn’t help that the bank has been battered by scandal, losing billions when Archegos Capital Management collapsed, mounting losses on loans to failed finance company Greensill Capital, and fines that totaled hundreds of millions for its involvement in a loan scandal in Mozambique.

Ulrich Koerner, who was hired earlier this year to implement a major overhaul of the investment banking unit, sent a memo to Credit Suisse staff reassuring that all was well. Unfortunately, that memo triggered further speculation about the health of the business. It seems that investors were assuaged by the fact that Credit Suisse currently has more than $9 trillion in assets and billions in excess cash. Crisis averted… at least for now.

In short, U.S. investors bought stocks on the back of the three Ps: the BoE’s intervention suggest that a U.S. Federal Reserve (Fed) Put is still in play; some positive early signs that inflation is moderating implies the possibility of a Fed Pause in their interest rate trajectory; which opens the door to a Fed Pivot by the end of the year.
Further positive evidence that inflation is easing can be found in the current yield on U.S. Treasury Inflation Protection Notes (i.e., TIPs) which are trading as if inflation will abate to the Fed’s target rate as early as next year.

Given these signs, we could assume the risk of hanging from a very weak limb and take the view that the October surge represents a change in momentum. This thesis is predicated on the premise that the June low was likely a bottom. At the very least, that 3,666 price point had significant support. When the S&P 500 Index broke the June low in September, the next major support was 3,585 which is where the S&P 500 closed at month-end. For some perspective, the difference between these price points is 2.24%.

This “change-in-momentum” thesis is predicated on two conditions: 1) the difference between the September and June low on the S&P 500 index is nothing more than a rounding error; and 2) assuming the first condition is reasonable, the September month-end close effectively represents a retest of the June low.

This thesis does not rely solely on technical analysis. We are witnessing a change in macro-economic fundamentals, which is shifting investor sentiment. We believe real-time inflation is falling… dramatically! Every inflation datapoint is declining, including the influential housing market and the impact that has on rents. As we have pointed out in previous reports, accommodation costs are a lagging indicator that takes time to show up in the inflation data. We expect to see the impact from these numbers in the next couple of inflation reports. If this flows through as we expect, the Fed will likely end this rate hiking cycle at the mid-December meeting.

You can also find evidence of capitulation in the CBOE Volatility Index (symbol VIX) which is the markets’ primary fear gauge. In the last ten days, the VIX topped out at 34 and the VIX curve began inverting. In other words, the longer term VIX futures were trading at a higher value than the near-term futures.

There are other seasonal factors that could point to a continuation of the October rally. The yearend is typically good for markets, thanks to a combination of factors, including window dressing by institutions, tax considerations, and investing yearend bonuses, which can spark so-called “Santa Claus” rallies.

What we expect to see next, is a shift in sentiment from the analysts’ community. They are usually late to the game but can be influential in propelling the second and third leg of this rally. Given the beaten-down nature of stocks, there are reasons to become more aggressive. Especially if macroeconomic fundamentals hold up, which in a best case – not a base case – leads to a Fed pivot.


There is little doubt that rate hikes will continue to slow growth this year. However, longer-term, the bulls can hang their hat on the likelihood of a Fed Pause/Pivot and price stabilization.

Obviously, we must weigh optimism against uncertainties that defy probability assessments. A case in point is the Russia-Ukraine conflict that, combined with OPEC cutbacks, has caused sharp increases in the price of oil, gas and other commodities. When you add inflation and tight monetary policies to the mix, it is hard to conceive of any scenario in which the global economy avoids a hard landing.

The question is not whether a recession is likely, but how long will it last? In terms of impact of this outlook, one must recognize that financial markets are forecasting mechanisms where participants constantly weigh tempered expectations for 2022 and expectations of a transition to a robust recovery over the next several years.

There are some key points to consider as we enter the fourth quarter of 2022. We believe the hawkish tone emanating from the Fed will abate by the end of the year. Whether that causes a full-scale pivot will hinge on the impact wage demands are having in labor intensive sectors like restaurants, hotels, transportation, etc. There are also overhanging concerns about the trajectory of the pandemic with particular emphasis on how that impacts global supply chains. We will attempt to examine each of these concerns in this section.

Interest Rates

When you think about the Fed’s dual mandate of optimum employment and price stability you can understand how the tight U.S. labor market has allowed the central bank to focus on the above-target inflation. Not only has the Fed removed the pandemic-era stimulus, policymakers have signaled their intent to raise rates aggressively until they hit a pre-determined neutral territory , estimated to be 4% or 4.5%, by year end.

The expectation is that the U.S. economy will grow by less than 2% by yearend (see chart below of Fed GDP expectations). But given the tight labor market, the U.S. economy is likely strong enough to continue growing under its own momentum.

However there are also concerns, echoed by some economists, that persistent inflation will force the Fed to hike interest rates well past neutral territory, and this would make a recession more likely.

At this point, we think the main issue pressuring price stability is supply chain friction. Monetary policy has no impact on supply chains, which are still hampered by COVID lockdowns and geopolitical risks. That said, the supply of goods should normalize by the first quarter of 2023. In that scenario, boosting borrowing costs above the neutral range seems unlikely because it might tip the economy into a longer recession that causes a spike in unemployment.

If price pressures subside over the next year as expected, the Fed is likely to hold rates near their natural equilibrium and perhaps drift lower, which would support a period of sustainable growth, stable prices and low unemployment. Such stable long-term inflation expectations by bond investors and professional forecasters will be reassuring to the Fed, allowing it to continue the quantitative tightening program that began in earnest in September.

Real Estate

The housing market is uniquely sensitive to rising interest rates, since most home purchases are financed with long-term mortgages. Higher borrowing costs could erase some of the pandemic-era run up in home prices, which was largely driven by historically low mortgage rates.

Mortgage rates have already climbed three percentage points from their pandemic low, reducing potential homeowners’ purchasing power by around 33%. As homeownership becomes more expensive, institutional investors, who get more favorable rates, will likely seize the opportunity to develop more rental housing. As for homebuilders, we doubt that weaker housing prices will slow residential construction because there is still such a significant undersupply in North America’s housing stock.

Supply Chains

Inflationary pressure is likely to ease in the first half of 2023 as supply chains return to normal. Supply chain bottlenecks remain but resulting price pressures are concentrated in durable goods, especially motor vehicles and electronics.

Geopolitical risks exacerbate the problem. Especially in the short term. China’s COVID-19 lockdowns will continue to disrupt global merchandise flows. However, we think the Chinese Communist Party, which is meeting to select a leader for another five years, may signal their willingness to ease their zero-COVID policy by the end of the year.

Commodities, propelled by the ongoing war in Ukraine, are also problematic. Energy markets are especially tumultuous as the war disrupts global supply chains. These disruptions have caused growth forecasts to be downgraded for the Eurozone and China.

U.S. Dollar Potency

Because the U.S. economy is relatively strong, the Fed’s rate hiking cycle is more aggressive than many of its trading partners. The Bank of Japan is still aiming to hold 10-year JGB yields down to stimulate its domestic economy. The European Central Bank has been reluctant to tighten in the face of economic dislocations caused by the war in Ukraine. The Bank of China is maintaining an accommodative monetary posture as the nation faces a wave of COVID-19 lockdowns.

The disparity in central bank policy has sent the trade-weighted value of the U.S. dollar up 10% against foreign currencies. The dollar’s strength is pushing down the cost of imported merchandise, which could shave a full percentage point off inflation in the second half. On the other hand, a stronger dollar will be a major headwind for S&P 500 companies that derive 60% of their revenue from offshore sales.

The Impact on Financial Markets

Stocks have fallen from record-high valuations as interest rates rise, but the market should stabilize as price pressures ease and the Fed approaches a more neutral posture. The market’s losses also likely reflect fears of further economic dislocation from the war in Ukraine.

Investors have always understood that interest rates would eventually rise. Financial markets have now discounted the removal of monetary stimulus. At the same time, profits remain at historically high levels, thanks in part to actions taken during the pandemic that have boosted efficiencies.

Personal Consumption Expenditures

The Personal Consumption Expenditures (PCE) index is the main gauge used by the Fed to predict the trajectory of inflation. PCE represents household expenditures and is compiled by the Bureau of Economic Analysis (BEA). The PCE price index measures price changes in consumer goods and services exchanged in the U.S. economy.

The Consumer Price Index (CPI) is the best-known economic indicator and gets the most attention from the media. But the Fed prefers to use the PCE Price Index when gauging inflation and the overall economic stability of the United States.

The Fed prefers the PCE as this metric is composed of a broad range of expenditures. The PCE Price Index is also weighted by data acquired through business surveys, which tend to be more reliable than the consumer surveys used by the CPI.

The CPI, on the other hand, provides more granular transparency in its monthly reporting. Economists studying the data can clearly see categories like cereal, fruit, apparel, and vehicles.

Another difference between the PCE index and CPI is that the PCE uses a formula that allows for changes in consumer behavior that occur in real time, while these adjustments are not made in the CPI formula.


The PCE index isn’t as well known to the general public as the CPI. While the CPI uses household surveys created by the Bureau of Labor Statistics (BLS) to determine the direction of prices, the PCE index is much broader. That’s because it takes data directly from businesses and corporations while taking GDP into account.

The PCE Price Index considers a broader spectrum of goods and services, notably those purchased by all households across the country. The CPI accounts only for households in urban settings.

The PCE price index is also much less volatile compared to the CPI, which is influenced by major price movements in certain products like gasoline. The PCE price index smooths out major swings.

These factors result in a more comprehensive measure of inflation. The Fed depends on the nuances that the PCE Price Index reveals because even minimal inflation can be considered an indicator of a growing and healthy economy.


While it is the preferred metric used by the Fed, there are some distinct problems with the PCE index. One is that it considers GDP – a figure that is only measured and reported on a quarterly basis. But the PCE is reported every month by the BEA. The agency must fill in the gap by using retail sales every month.

Another disadvantage to the PCE index is that it is very broad. It uses information from both households and other entities such as nonprofits, governments and corporations.

What to watch

The evolution of price pressures will determine how the last quarter of 2022 plays out. Watch for the inflation expectations implied in bond yields (note our previous comments on TIPs) to settle toward the Fed’s 2% target. The Fed will release a new interest rate forecast after its October meeting, showing policymakers’ expectations (the latest data from the St. Louis Fed can be found on the following chart).



Based on recent ‘Fed speak’, the U.S. central bank intends to reduce its balance sheet by U.S. $90 billion per month beginning in September. That pace may change, but with headline inflation running at 8.6%, or 6.0% when excluding food and energy, it is unlikely that gyrations in the equity markets will alter the Fed’s path to normalization.

While normalization has a direct impact on the bond market, equity investors are paying close attention. For good reason. In 2021 the ‘don’t-fight-the-Fed’ mantra worked to perfection as easy money propelled equity valuations to new highs. Now, in a rising rate environment, investors are witnessing the negative consequences of ‘don’t-fight-the-Fed’.

While it is difficult to prove cause and effect, one cannot help but ask if quantitative easing triggered the 2020-2021 market rally and whether concerns about quantitative tightening are the main cause of the sharp declines in 2022. More importantly, will continued quantitative tightening potentially deepen the equity bear market? While these questions cannot be answered with certainty, S&P 500 Annual Dividend Index.

At first glance the relationship between the S&P 500 Annual Dividend Index and the S&P 500 itself is not entirely obvious. However, futures contracts might provide a clue. Initially, if one adds up the value of the 11 annual contracts and compares it to the S&P 500 there doesn’t appear to be a close connection between the two. In fact, since the beginning of 2017, S&P 500 Annual Dividend Index Futures have barely changed their view of dividends over the next decade. In early 2017, the S&P 500 Annual Dividend Index priced in around 540 index points worth of dividends over the decade from 2017 to 2027. As of mid-June 2022, they price about 550 index points worth of dividends to be paid over the decade from 2022 to 2032. In contrast with the stability of investor expectations for dividends, the S&P 500 itself rallied from 2,200 to over 4,700 before falling back to 3,800 (see chart to the right).

However, it’s not the nominal dividends that are the most interesting but rather the net present value (NPV) of future dividends as implied from S&P 500 Annual Dividend Index Futures, discounted using U.S. Treasury yields. Prior to the Fed beginning its pandemic QE program, the S&P 500 moved more-or-less in lockstep with the NPV of expected dividends as priced into the S&P 500 Annual Dividend Index Futures contracts.

Indeed, this implies that much of the reason why stocks went higher in 2019 and early 2020 was because interest rates were falling, thus raising the NPV of anticipated future dividends. In late February and early March 2020, the NPV of the dividends and equities fell together. However, starting in late March 2020, as the Fed began expanding its balance sheet, the two series diverged. Stocks soared far beyond the levels suggested by the NPV of dividends. By late 2021 the NPV of dividends implied an S&P 500 fair value of perhaps 3,800 while the index rose to almost 4,800.

The NPV of anticipated dividends peaked in November 2021, about a month and a half before the peak in the S&P 500.

Since then, the NPV of future dividends has fallen for two reasons: investors have become less optimistic about nominal dividend payments than they were expecting a few months ago; and higher treasury yields have increased the discount rate applied to the present value calculation.

That said, the S&P 500 remains far above its pre-pandemic/pre-QE ratio versus the NPV of future dividends. This suggests a risk that, as the Fed shrinks its balance sheet (quantitative tightening) equity prices risk catching up to the NPV of dividends on the downside. If stocks returned to their pre-pandemic/pre-QE ratio versus the NPV of future dividends today, that would imply an S&P 500 of around 2,700 or about one third below recent levels. This isn’t to suggest that the S&P 500 should, or is likely to drop, that far. Rather it does highlight the potential risk that quantitative tightening poses to equity investors if the pandemic QE did, in fact, inflate asset values, as the abrupt change in the ratio between the S&P 500 and the NPV of future dividends suggests may have been the case.

What is clear is that over a long period of time there has been an inverse relationship between the level of bond yields and various valuation measures for the equity market. For example, when long-term bond yields were low during the 1960s, the equity market supported a high market-cap-to-GDP ratio. The same has been true in recent decades. By contrast, in the higher inflation and interest rate environment of the 1970s and 1980s, equities had much lower market-cap-to-GDP ratios.

Higher bond yields reduce the NPV of future cash flows, including dividends. Additionally, higher bond yields might also attract investors away from equities and into government bonds. Both are reasons why higher rates of inflation and higher bond yields pose a threat to future equity valuations.

[1] A neutral level of policy rates would imply that monetary policy is neither accelerating nor restraining economic growth.
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Richard Croft, Chairman & CIO

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