Interest Rates Stronger Than Earnings, Will They Shake the October Stock Market?

In 2018, the Fed implemented interest rate normalization along with 'autopilot' mechanical quantitative tightening, and former President Trump strongly criticized Chairman Powell's actions. Immediately after the November midterm elections, the market plummeted around Christmas, falling 20% from its peak, leaving a lesson.

At the time, the Fed implemented interest rate normalization along with mechanical quantitative tightening, dubbed 'autopilot,' and former President Donald Trump strongly criticized Chairman Powell's tightening measures.

As a result, the market experienced a sharp decline around Christmas, which is cited as an example of how the market can fall even after midterm elections.

The market rebound in October 2022 stemmed from expectations of the Fed's interest rate hike cycle ending. Past cases confirm that the Fed's policy direction, rather than the midterm elections themselves, is the key variable driving the stock market.

Indeed, the market rebound in October 2022 was largely driven by expectations of the Federal Reserve's interest rate hike cycle coming to an end.

The market's primary focus is currently on the Fed's future actions.

The market is currently watching the August and September PCE inflation data.

However, after remarks by New York Fed President John Williams, the probability of a rate hike adjusted to around 40-50%, somewhat alleviating uncertainty.

The market is currently focusing on the release of the August and September Personal Consumption Expenditures (PCE) price index data to gauge the Fed's next move.

Unlike rapid, elevator-like increases, stair-step increases with occasional pauses allow the market time to adapt. However, past cases show that three or more consecutive increases cause shock and instability in the market, so unconditional expectations for an end to hikes should be wary. Based on past examples, unconditional expectations of an end to hikes should be wary.

A rapid, elevator-like ascent places a significant burden on the market. Judging from past cases, an unconditional expectation of an end to rate hikes is ill-advised.

Treasury yields react differently depending on the Fed's policy. The benchmark interest rate is immediately reflected in short-term bonds of 2 years or less, while long-term bonds are more heavily influenced by complex factors such as real interest rates, economic growth, and supply-demand issues due to fiscal deficits.

Long-term Treasury yields, on the other hand, are determined by a complex interplay of various factors, including real interest rates, economic growth, and term premiums.

Recently, structural supply and demand factors such as the U.S. fiscal deficit and debt issues have also been reflected in long-term yields, leading to different trends compared to short-term yields.

The U.S. has chronically suffered from fiscal and trade deficits, but thanks to dollar hegemony, it has maintained a virtuous cycle of importing cheaply from abroad and issuing national debt.

In the past, dollars earned overseas were reinvested in U.S. Treasury bonds, becoming a key driving force supporting supply and demand in the U.S. market.

After the Nixon Shock in 1971, which ended the dollar's convertibility to gold and shifted to a dollar standard, the dollar enjoyed its status as the international reserve currency.

However, during the Russia-Ukraine war in 2022, the freezing of Russia's dollar assets highlighted the risk of dollar sanctions, leading to a loss of confidence in the dollar's status.

Subsequently, central banks in countries distant from the U.S., including China, have shown signs of weakening dollar hegemony by reducing their purchases of U.S. Treasury bonds and increasing their purchases of physical gold.

Despite the trend of countries reducing their share of U.S. Treasury bonds, investment in U.S. stocks remains active.

In particular, investment demand for artificial intelligence (AI)-related stocks is acting as an important factor in defending the dollar's value, and the negative stance of former President Trump and former Treasury Secretary Steven Mnuchin on AI regulation is also aimed at preventing this capital outflow.

The U.S. economy is currently maintaining a forced rally through AI investment, but if the real economic effects of AI do not appear early, it could only lead to short-term overheating and inflation.

Just as it took time for the effects of the internet to materialize after the dot-com bubble in 2000, if AI productivity effects are slow, the U.S. stock market could experience a long-term slump, similar to a 'lost decade.'

In such a situation, U.S. stocks could lose their appeal, and emerging markets like Asia could see a relative rally.

Improved corporate productivity is an important variable for securing the justification for these AI investments, and next year is expected to be a crucial turning point for the visualization of AI effects.

It is suggested that including a certain proportion of real asset-related stocks, such as gold and copper, in a portfolio is important to prepare for dollar weakness.

This aligns with the strategies of asset allocation experts like Ray Dalio, emphasizing the need for a balanced allocation across domestic and international stocks and real assets.

Data analysis over the past 70 years shows that the market tends to prefer a state of divided power.

The S&P 500's average annual return was highest when power was divided between the party that elected the president and Congress.

Specifically, with a Democratic president and a divided Congress, the average annual return was 16%, and with a Republican president and a divided Congress, it was 15%, showing that market performance was superior in a divided power system than in a unified Democratic system.

A paradoxical phenomenon is occurring where spending actually increases as they clash over the budget agreement process.

However, in practice, this combination leads to a paradoxical tendency where Democrats and Republicans clash and actually increase spending during the budget agreement process.

There are also instances from the past, such as during the Nixon-Ford administrations, where this power structure coincided with economic recession and stock market declines.

Historically, 10-year Treasury yields (black line) and corporate capital expenditures (blue line) have shown a high correlation.

Increased overall capital expenditures, including AI, signify improved economic growth and are also a key factor driving up long-term interest rates.

An analysis suggests that in the current economic situation, where nominal growth is around 6%, interest rates reaching 6% could be a natural outcome of this trend.

In particular, if this index surges even with a slight drop in interest rates, it signals unstable supply relative to demand, so investors should proactively identify market risks through it.

Even if Treasury yields slightly decline, a surge in the MOVE index should be interpreted as a signal of unstable supply relative to demand in the bond market.

Therefore, investors should not feel complacent just because the VIX index is low. It is necessary to monitor the trends of the MOVE index daily to assess bond market volatility.

The September stock market held up better than expected, despite upward pressure from oil prices and interest rates.

However, due to a high starting point, the October stock market is expected to see a strong clash between favorable corporate earnings and macro variables, especially persistently high interest rates.

Micron's earnings announcement is an important short-term variable, but the market's doubts about whether interest rate levels will be maintained will continue, so vigilance against a surge in the MOVE index is necessary.