The U.S. economy continued to grow, and the U.S. Federal Reserve (Fed) looked increasingly likely to be near its peak in interest rates—but uncertainty and market volatility rose in the third quarter.
After a strong July, and an uneven August, the S&P 500® Index fell sharply in the second half of September. The U.S. large cap stock index was down 3.65% for the third quarter after three straight quarters of positive returns. (The S&P 500 is a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.)
The recent spike in 10-year Treasury yields played a major role in the stock market's September swoon. The benchmark yield blew past the 2022 high and closed the third quarter at 4.57%, a level not seen since 2007.
The core problem for both stocks and bonds were that growth looked to be softening at the same time the Fed became more hawkish—or, more precisely, the market was finally accepting the message that the Fed will remain hawkish until inflation approaches its target level, closer to a 2% long-term average rate.
The impact of tighter financial conditions, thanks to the Fed’s previous rate hikes, became more apparent over the quarter. Real rates—the interest rate paid above the current inflation rate—spiked as Treasury yields surged while inflation expectations remained relatively stable. This puts stress on rate-sensitive industries, such as banking and commercial real estate, as well as the consumer.
Unsurprisingly, the much-lauded strength of the consumer continued to ebb over the quarter, particularly in lower-income segments where loan delinquencies rose and short-term pay-day loans rose 35% in the past year, according to data from LexisNexis. More broadly, total credit card debt surged to above a record $1 trillion, according to the Fed, while the latest Fed study of household finances indicated that most U.S. households have depleted their excess savings (built up in part by pandemic stimulus payments) to the point where they now have less than they did before COVID. While the surge in employment late in the quarter is good news for the consumer, it remains to be seen whether September’s surge is an outlier or results in an even more hawkish Fed.
Meanwhile, inflation remains high. While it has drifted lower recently, the 3.3% year-on-year rise in the July Core Personal Consumption Index (PCE) measure, a common gauge of inflation, is still well above the Fed’s target rate. And we believe the last percent or so will be the hardest to wring out.
Indeed, stubborn inflation is why we think the Fed has been increasingly clear about its higher-for-longer message. At the Fed’s September meeting, they announced a target policy rate of 5.0% at the end of 2024 and 3.9% two years out. This was a significant rise from the Fed’s expectations just six months ago that the same rates would end 2024 at 4.3% and 2025 at 3.1%.
It was a difficult quarter for financial markets. That said, we continue to believe that uncertainty, and thus volatility, is particularly high around turning points in the economic cycle. While the short-term effects of volatility can be painful, these same periods can also offer opportunities for actively managed investment portfolios.
For more on the economy and our outlook for the markets, see: Thrivent 4th Quarter Market Outlook, by Chief Investment Strategist Steve Lowe