Market Commentary: August 2023

August Tug of War

It was a challenging month across markets. Signs of moderating inflation along with still robust economic conditions were offset by an increase in interest rates and concerns that the Fed could keep interest rates higher for longer than may be currently priced into markets. Expectations for an economic “soft landing” appear to be a growing consensus, but the substantial monetary tightening of the past two years and the Fed’s assessment that inflation remains too high, has kept uncertainty high.

• Equity markets declined across the board in August, with the S&P 500 and NASDAQ posting their first monthly declines since February.^{1 2}
• Longer-dated treasuries sold off in August, pushing the 10-year rate up to a 4.34% on August 22nd, the highest since November 2007.³
• Q2 earnings fell from year-earlier levels for the 3rd consecutive quarter, but forecasts point to a bottoming in Q3.⁴
• Money supply measures have moved higher since April after a year of sharp declines.⁵
• Inflation held steady in July from June, but the change from a year earlier ticked up slightly and remains well above the Fed’s 2% target.⁶

Equity Returns: August and Year-to-Date 2023

Source: S&P Dow Jones Indices⁷, NASDAQ⁸

Stocks faltered in August

• All equity categories saw declines in August despite some strengthening to end the month.⁹
• Economically sensitive small cap, value and emerging market stocks fared the worst.¹⁰
• No region showed positive returns in August, with European and Asia ex-Japan stocks posting the weakest returns.¹¹
• Energy stocks eked out a small gain for August, the only S&P 500 sector to post a positive return. Utilities and consumer staples fared worst for the month, remaining the weakest performers so far in 2023.¹²

Fixed Income Returns: August and Year-to-Date 2023

Source: S&P Dow Jones Indices

The Fed Remains on the Job

There was no Fed meeting in August, and thus no policy changes to short-term interest rates, but yields for longer-dated treasuries increased during the month. Still, at the annual conference in Jackson Hole, Fed Chairman Powell reiterated that the job to bring down inflation was not yet over: “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective”.¹³

• Fixed income returns were negative in all segments except ultra short term Treasury bills.¹⁴
• Non-US government bonds (emerging and developed markets) fell the most during the month. ¹⁵
• The rise in long-term rates helped lower the “inverted yield curve” measure (10-year treasury yields less 2-year yields) by 25 basis points (after a 15 basis points drop in July).¹⁶
• A negative spread on this measure has historically been associated with a high risk of recession.

Money Supply and Inflation

Economist Milton Friedman famously said that inflation “is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”¹⁷ He was specifically referring to “persistent” inflation rather than supply shocks that may drive prices higher temporarily. The chart below shows a broad measure of the “quantity of money” for the U.S. The sharp rise in this M2 gauge of the money supply in the early months of the pandemic is easy to see. Of course, that surge was designed to rapidly and substantially address the dramatic drop in the supply of goods when the global economy shut down in the first months of the Covid pandemic.

Money Supply: M2

Source: Board of Governors of the Federal Reserve System. M2 consists of currency, bank deposits, short term time deposits and money market funds.¹⁸

The jump in the supply of money offsetting a temporary smaller supply of goods would not necessarily have created persistent inflation, but critics of the Fed would instead point to the continued above pre-pandemic trend growth in M2 in the months after May 2020 as a large reason why inflation rose to such elevated levels in 2022 and is now requiring aggressive tightening efforts by the Fed to bring down. These efforts certainly increase the risk of recession.

Just as increases in the money supply can fuel inflation, reductions can serve to lower demand and prices. The impact is not immediate, however. The substantial declines in M2 that began in the spring and summer of last year have indeed begun to impact inflation. The chart below shows the year-over-year change in inflation for the Personal Consumption Expenditures index, the Fed’s preferred measure of inflation when removing the volatile food and energy components. Much of the recent rise and fall in inflation comes from those volatile commodities, especially energy prices.

Year-Over-Year Change in Inflation

Source: US Bureau of Economic Analysis, Personal Consumption Expenditure Price Index¹⁹

The headline inflation numbers (those that do not exclude food and energy) have been cut in half from the peak in June 2022. That feels like substantial progress, but there’s still another halving of inflation needed to bring the rate down to the Fed’s target of 2%. The picture is less encouraging when removing food and energy prices, with the Core PCE still 2.5 times higher than the Fed’s goal. The debate among investors and also within the Fed is whether there has already been enough tightening to bring these inflation numbers down to the target or if the Fed will have to restrict policy and raise rates further to finish the job. It’s a difficult question to answer given the imprecise nature of how monetary policy impacts inflation and the economy. The markets seem to have priced in no more rate hikes from the Fed as well as a soft landing for the economy so any changes in that trajectory would almost certainly drag down prices for both stocks and bonds.