September 18, 2023 – Markets are directionless, torn between better economic activity and an increase in storm clouds from labor unrest to China. What is crucial is the future trend for interest rates. Investors will parse this week’s FOMC meeting for clues, but probably won’t get a much clearer picture for their efforts.

Stocks have been trading sideways in a directionless pattern for the past month. On the plus side, earnings have exceeded forecasts and the economy continues to grow at a rate faster than economists had predicted. But that has been countered by a series of concerns:

1. Interest rates, particularly at the long end of the curve, have been slowly climbing. The 10-year Treasury yield is back at highs not seen since last October and threatens to move higher.

2. China, a pillar of growth for the past several decades is slowing down as its population starts to shrink and Communist leadership grapples with near-term economic concerns stemming in part from too much debt and a slow recovery from Covid shutdowns.

3. Higher oil prices.

4. Sustained wage pressure. Although the number of new jobs per month has been trending lower, and job openings are in decline, wage rates are still rising well in excess of 4%. Worker unrest is demonstrated by increased strike activity. 2023 was already the biggest year for strikes in two decades before auto workers walked off their job last week.

5. Tech stocks have led the market for most of 2023 as optimism over the rapid growth of Generative Artificial Intelligence lifted expectations. But it appears that reality and expectations have reached a balance point. Recent earnings reports from companies like Oracle# and Nvidia#, while good, failed to lift expectations further. As a result, their share prices have stalled, at least for the moment. New leadership has yet to surface.

6. Demand for new homes had energized the overall housing market even as demand for existing homes waned. However, with mortgage rates crossing 7%, even homebuilders are starting to see resistance.

That sets the stage for this week’s FOMC meeting. The immediate outcome of the meeting isn’t in question. The Fed isn’t going to change the Fed Funds rate from a range of 5.25-5.50%. It might even be done raising rates altogether. Instead, investors will parse every written word in the post-meeting statement, every spoken word in Chairman Powell’s press conference, and every dot in the dot plot forecasts of meeting participants for a hint to the future course of rates.

Such efforts are a waste of time. Consensus today is that the first rate cut will come around mid-2024. Whenever it happens, it will be dependent on the pace at which inflation declines between now and then, and the growth rate of the economy. The Fed has two mandates, price stability and sustaining economic growth. In 2022-2023, price stability became more important as inflation spiked out of control. It is still too high, but it is trending down and will continue to do so as long as real rates are notably positive. Without any further rate increases, the real rate will rise as inflation continues to fall. The closer inflation gets to the Fed’s 2% target, the sooner it can switch focus to overall growth. Right now, growth is still reasonably robust. Q3 growth could reach 3%. The Atlanta Fed is forecasting closer to 5%. Thus, at the moment, the focus continues to be on inflation, not sustaining growth.

But that should change in the months ahead. Student loan repayments restart this fall. That will impact consumption. Higher oil prices won’t hurt GDP per se but they will shift buying towards energy needs and away from discretionary spending. Some of the sectors that have led the economy for months, notably travel and leisure have started to falter. Domestic airline ticket demand is falling at a rate faster than normal seasonality suggests. Attendance at Disney World and nearby Florida resorts is down year-over-year. Retail sales are spotty. The outlook for Christmas as expressed by retailers is subdued. Even the dollar stores are feeling pressure. When the economy slows, lower income families feel the pain first. But whether the economy simply evolves into a soft landing or slips into recession is still unknown.

One factor that could influence that outcome is a financial surprise. In 2008, the economy was slipping into recession from the start. But the events of mid-September, when Lehman, Fannie Mae and AIG fell, caused outright angst. Americans didn’t know where their money would be safe. Treasury had to increase the size of insured deposits by over 150%. A slow economic deceleration threatened to morph into total collapse.

We got a hint of worry last spring when several regional banks failed, but the damage was contained. Americans at the time also had a cushion of savings left over from the pandemic. Will there be another shoe to drop? That’s anyone’s guess. There are seeds planted. Money supply is falling, commercial real estate assets are stressed from oversupply, lower occupancy and higher financing rates. The use of excess leverage by investors, small and large, whether it be on Treasury/futures arbitrage or speculation in 1-2 day options are symptoms. So far, none of these seeds have germination. There is no current crisis. But when rates remain elevated, money conditions tighten, banks come under increased regulatory scrutiny, and speculation increases, the odds of a serious problem increase. Again, I am not forecasting anything. Rather, I am raising a yellow flag to be watchful.

So, what gets markets moving up or down from here? Markets almost always flutter around an FOMC meeting. But this one isn’t likely to change the market’s course beyond 24 hours. Over the next few weeks, any progress or lack thereof settling high profile labor conflicts or avoiding a government shutdown could help or hurt. The first week in October will give us a better picture of economic activity in September, the most important month economically in the third quarter. Perhaps the most important indicator to watch is the direction of the 10-year Treasury. This morning it is back to exactly the high yield of last October. If it moves noticeable higher, that would spell trouble for stocks. Conversely, if either good inflation news or a deteriorating economy pushes the yield back down toward 4%, that would help. In technical terms, is this a double-top or a breakout to a fresh high for yield?

September is often a seasonally weak time for stocks, in large part because of the relative absence of data, allowing investors to fester and worry a bit about the unknown. Over the next few weeks, we will learn more pieces to the puzzle which may better define the market’s direction in the weeks ahead, at least until Q3 earnings season begins in mid-October.

Today, Lance Armstrong is 52. Former Phillies star Ryne Sandberg is 64.

James M. Meyer, CFA 610-260-2220