Stocks suffer rough September

The stock market sold off during September, following a modest decline in the prior month. The S&P 500 is down about 7% off its year-to-date high; however, it is still up an impressive 11.2% through the first three quarters of the year. As has been widely discussed, much of the gain can be attributed to a handful of big tech stocks, dubbed “the magnificent seven.”

• The health of a stock market rally can be determined by how broad the participation is
• If you look at the equally weighted S&P 500, the recent sell-off amounts to about 9% and leaves the index flat for the year
• Another way to look at it is the average stock in the index is basically flat on the year
• The sell-off in September is not surprising, given its a seasonally weak month
• Companies will begin to report quarterly earnings in a few weeks, and given the overall positive seasonality of the fourth quarter, it will be interesting to watch if the rally can continue
• The lack of broad participation is something of note, however, and something we have been very mindful off

Rates at 16-year highs

Interest rates on long-term treasuries continued to rise this week, although they finished the quarter slightly off their highs. The 10-year treasury ended the quarter at 4.57% while the 30-year ended at 4.7%. These are levels not seen since late 2007 when we were in the early stages of the Global Financial Crisis.

• There is much debate about why rates have been rising
• Some are pointing to the massive amount of new debt that needs to be issued to fund our deficit
• Relatedly, some have pointed to less demand from foreign governments
• Others are pointing to the Federal Reserve doing Quantitative Tightening (QT); instead of buying treasuries, letting their balance sheet run-off
• Still, others point to a new era of positive real rates (interest rates - inflation) after over a decade of low to negative real rates
• All of these arguments have some merit, but the takeaway seems to be that we are in a new regime
• Relatedly, TLT, the iShares 20-year treasury bond ETF, reached a drawdown of >50% from its all-time high in 2020
• TLT is a widely used instrument for long-term fixed-income exposure, representing what is supposed to be the “safe” portion of an investment portfolio
• A 50% decline over three years is truly a stunning move for such an asset

Commercial Real Estate trembles

Ever since the Federal Reserve began to raise interest rates, there has been an acute focus on assets sensitive to interest rates. Commercial Real Estate (CRE) is very sensitive to interest rates, given the significant use of debt financing. However, over a year and a half into the Fed’s hiking cycle, we have seen anecdotal evidence of stress, but the issue has been far from systemic. As we enter the last quarter of the year, we are finally starting to see some statistical signs of stress, with the main outlier being the Office sector.

• Charge-offs on bank balance sheets can be seen spiking for Office CRE (as per chart below)
• When a loan on a bank’s balance sheet shows signs of trouble, the bank will “charge-off” the debt and take the expected losses
• Other data, including delinquency rates and criticized loans, show similar trends
• Lodging (hotels) is the other sector starting to show signs of stress in some parts of the country (see 2nd chart)
• The longer interest rates stay higher, the more we expect to see problems in CRE as more properties will need to refinance their debt at much higher interest rates
• In many of these situations, you will see the lender (issuer or holder of the debt) take over the asset from the landlord