DAL - More Pain Ahead

2023-10-02 11:23:59 ET

Summary

• In September, equities had their worst monthly performance since December and their poorest quarterly results since Q3'22.
• Three concerning trends emerged during the quarter: rising interest rates, resurfacing inflation, and a deteriorating job market.
• These trends are likely to persist throughout the fourth quarter and possibly into the next year, bringing more pain to investors.
• We discuss these bad omens for the market and how I am positioning my portfolio in front of this approaching storm in the paragraphs below.

On the eve of recessions in 1990, 2001, and 2007, many Wall Street economists proclaimed the U.S. was on the cusp of achieving a soft landing, in which interest-rate increases corralled inflation without causing a recession . - Nick Timaros, WSJ

Trading closed out for September and for the third quarter on Friday. It was more than a forgettable month for investors as equities turned in their worst monthly performance since December of last year. The S&P 500 was down 4.9% for the month and 3.7% for the third quarter. The NASDAQ had it worse and dropped 5.8% for the month and 4.1% for the quarter.

Thanks to surging oil prices during the quarter, energy was the only one of 11 S&P sectors to end the quarter in the black. More concerning was that there were trends that emerged during the quarter. These are bad omens as we enter the fourth quarter as they are likely to persist through at least year end. This could mean there is more pain ahead for investors as we begin the final quarter of 2023.

Interest Rates Rose At An Accelerating Clip

Interest rates help determine what consumers pay on auto loans, credit cards and mortgages. They affect the costs of servicing our ballooning national debt and affect businesses from all industries, or at least the ones that carry debt.

The news on this front was bleak if not downright dismal as you can see from the chart above. The yield on the 10-Year Treasury moved up sharply to just under 4.6% during the quarter, its highest mark since 2007 just before the Great Financial Crisis. Rising rates are causing consumer delinquencies to tick up to their highest point since the spring of 2020 during the lock downs. Both credit card and auto loan delinquencies recently surpassed their pre-pandemic levels as well. The average 30-year mortgage rate is now well north of seven percent and at its highest point in 22 years.

This is happening as total credit card debt just recently surpassed the $1 trillion mark for the first time and auto loans stand at a record $1.6 trillion. With all the excess savings from pandemic largess now fully spent, this will only get worse in the months and quarters ahead.

However, I think investors need to focus on what is going on in the commercial real estate or CRE market more than anything else in regard to debt servicing. As I noted in July, CRE has the potential to be the ' subprime ' of the next bear market, especially the retail and office sub-sectors of the space.

As Debt maturities come due, many properties who have seen their asset values fall in recent years will have to roll over their obligations at much higher rates. This as delinquency rates are already marching quickly higher. According to Trepp, Bank CRE mortgage delinquencies rose in the second quarter of this year, with the office sector experiencing a dramatic rise in its delinquency rate, up to 4.9% from 2.7% in the first quarter and just 1.6% at the end of last year. It stood at 5.58% at the end of August. I don't what ' Jingle Mail ' is called in the CRE industry, but I have a feeling we will all find out together in 2024.

Inflation Bounced Back

The inflation battle did end on a high note for the quarter as core PCE rose by 3.9% on a year-over-year basis in August as expected on Friday. This was the first time in two years that the Fed's preferred inflation gauge has dropped below 4%. However, this is still far above the central bank's ' official ' two percent target.

Inflation proved a stubborn enemy during the quarter, nonetheless. Oil went from $70 a barrel at the start of the quarter to close just above $90 a barrel by the end of it. This pushed up the costs throughout the energy complex with gasoline getting above $6 a gallon in some parts of California.

The CPI also started to move back up during the quarter. After being brought down from 9.1% in June of 2022 to 3.0% in June of this year, the CPI moved up to 3.2% in July and then to 3.7% in August. We are also seeing a ' Wage-Price Spiral ' starting to form for first time in many decades.

Pilots got approximate 40% increases within their new four-year contracts at American Airlines ( AAL ) , Delta Air Lines ( DAL ) and this week they ratified one with United Airlines Holdings ( UAL ) . The teamsters won a massive new five-year contract with United Parcel Service, Inc. ( UPS ) .

The UAW is currently in a large and escalating strike with the Big Three auto manufacturers initially demanding four-year wage gains similar to the pilot's union. The sides remain far apart, and this labor action could drag well into October. The Culinary and Bartenders Union just gave strike authorization ahead of their contract talks covering 60,000 members in Las Vegas and Reno and California just passed a law mandating a $20 an hour minimum wage for fast-food workers in the Golden State.

None of these developments are going to help the Fed get inflation down to three percent, let alone their two percent target. This means interest rates are likely to remain much higher than longer than was believed at the beginning of the quarter.

Jobs Market Deteriorated:

Despite a headline unemployment rate that remains solidly below the four percent rate, the jobs market deteriorated in the fourth quarter.

We continued to see positive monthly job growth in July and August. However, that was due to part-time positions surging. Full-time jobs fell both in July and to a much lesser extent in August. In addition, jobs growth has been weaker than initially reported throughout the year. In fact, every single BLS jobs report has been revised down in 2023 in subsequent revisions.

The UAW strike and other possible labor actions could also negatively impact jobs growth in the months ahead. The jobs market could also be impacted to the downside should the government shutdown last any length of time. Finally, according to a recent survey from Challenger, Gray & Christmas, retailers only plan to hire 410,000 seasonal workers this holiday season. That is the weakest level since 2008.

Portfolio Strategy:

Given that market outlook, my current portfolio allocation remains extremely conservative along the following lines:

Short-term treasuries - 50%

Covered Call Holdings - 40%

Cash - 6% to 7%

Long dated, out of the money bear put spreads mainly against the SPDR S&P 500 ETF Trust ( SPY ) and the Invesco QQQ Trust ETF ( QQQ ) . 3% to 4%

And that is how I plan to minimize the pain the market is likely to deliver to investors in the months and quarters ahead.

I have never been one to ignore the signs. Unless, of course, it works in my favor. ? Jaida Jones

For further details see: