In the month of August, the red-hot equity markets finally took a pause, retracing some of the gains accumulated over the past few months. It was a period marked by notable shifts and mixed economic indicators that raised eyebrows across the financial landscape.
The S&P experienced a dip of -1.59% during August, despite the fact that an impressive 79% of equities reported earnings surprises. However, the brunt of the downturn was borne by small-cap stocks, with the Russell 2000 index plummeting by -5%. International markets were not immune to the turmoil, as the MSCI EAFE index fell by -3.8%, and China’s stock market took a more substantial hit with a decline of -6.1%.
In the economic sphere, the data presented a mixed bag of signals. Labor remained robust, with job numbers staying strong, but inflation continued to loom large, and there were ominous signs of contraction in the manufacturing sector.
The Federal Reserve, following its last rate hike in July, opted to maintain the status quo in August, assuring that September would also be spared. Bond markets underwent a correction, partly due to Fitch’s downgrade of the US government from AAA to AA+. This downgrade pushed 10-year Treasury yields up by 15 basis points, and the Bloomberg Barclays Agg index dropped by -.64% during the month. Surprisingly, oil prices rallied despite projections of slower global growth, retracing to levels last seen in November 2022.
Examining the US economic landscape, non-farm payrolls slowed to 187,000, and the unemployment rate crept up to 3.8%. Job openings also decreased slightly, and wage growth began to show signs of cooling. The manufacturing Purchasing Managers’ Index (PMI) continued its 10th month of contraction, reporting a figure of 47.6 in contrast to July’s 46.4. In contrast, the ISM Service sector index held strong at 54.5, indicating that consumer activity remained resilient.
Turning to Europe, the continent continued to face economic headwinds, with both the services and manufacturing sectors showing signs of contraction. The services sector dropped to 48.3, while manufacturing remained stagnant at 43.7%. Inflation remained stubbornly high at 5.3%, leading to continued rate hikes by the European Central Bank (ECB), now standing at 4%, and the UK at 5.25%.
China added to global economic concerns, as stress in the property sector, notably from companies like Country Garden and Evergrande property holdings, raised alarm bells. However, both services and manufacturing PMIs in China indicated expansion. Deflation signals started to recede, and the Renminbi found stability at a lower exchange rate.
Looking ahead, we anticipate that the Federal Reserve will maintain its restrictive rate policies beyond 2023, given that inflation persists above target levels. Notably, the S&P large-cap index is currently trading at an earnings multiple of 18.9%, while small and mid-cap stocks are valued at more conservative multiples ranging from 14 to 13.8 times. Europe presents a relatively more reasonable valuation at 12 times earnings.
Given the uncertainty surrounding market outcomes in the coming year, we believe it’s an opportune moment to consider adding to small and mid-cap equities in the US and exploring opportunities in the credit markets when favorable moments arise. Credit investments are now offering returns that resemble those of equities, especially in the senior tiers of the capital stack.
Additionally, our attention is drawn to alternative energy strategies and investments in Agri-Tech. These sectors stand to benefit from both cyclical and secular trends related to underinvestment and supply shortages in critical resources such as water, food, and energy on a global scale. Furthermore, we continue to emphasize the importance of monitoring disruptive trends in technology and bolstering cybersecurity measures in a rapidly evolving digital landscape.
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