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Q3 2023 Investment Commentary

Q3 2023 Investment Commentary

October 25, 2023

After posting impressive gains through the first half of the year, the third quarter of 2023 proved challenging for both stock and bond investors alike. Heading into July, markets were optimistic, and for very good reason. Concerns over the regional banks that shook the markets earlier this spring had subsided, and the debt-ceiling crisis had been averted. Meanwhile, inflation was moving lower, the Fed was pumping the brakes on interest rates, earnings held up, and the economy was taking it all in stride.

As we enter the final quarter of the year, not a whole lot has changed. Inflation still is moving in the right direction, the Federal Reserve is nearing the end of this rate-hiking campaign, and the economic data continues to suggest the U.S. will avoid a recession for the time being. With that said, there are valid reasons behind the recent decline. For the better part of this year, the markets had been pricing in a very high likelihood the central bank would shift course and begin cutting rates aggressively as early as next year. While inflation is falling, it remains well above the Fed’s target, and recent guidance from the central bank indicates higher rates may be around for longer than expected. This has led to significantly higher interest rates over the past couple of months, putting downward pressure on both stocks and bonds. In addition, valuations in the top-performing U.S. stocks, mostly technology related, had been well above their historical averages, and were arguably priced to perfection. The full impacts of higher interest rates still are unknown and will take time to filter through the economy. For now, we believe the markets are discounting this uncertainty, and will look to upcoming third-quarter earnings and margins for clarity.

Stocks – Energy Sector Leads the Way

The S&P 500 Index finished the third quarter lower by 3.27% in total return, while the technology-heavy Nasdaq Composite index fell by 3.94%. It has been a challenging year for small cap stocks, which took the brunt of the regional banking crisis earlier this spring and continue to face the prospects of higher interest rates. We saw this trend continue in the third quarter, as the Russell 2000 fell by 5.13%. Stocks in the energy sector were the lone gainer for the quarter, adding nearly 12%. Meanwhile, Real Estate and Technology stocks were the worst-performing sectors, falling by approximately 9% and 6%, respectively.

In international stocks, the MSCI EAFE fell by about 4.05% for the quarter, while the MSCI Emerging Markets Index fell by 2.79%. Most economies in other regions of the world have not been as resilient as the U.S., and parts of Europe are teetering on the brink of recession. With that said, weaker economies may result in more accomodative monetary policy, which could help bolster asset prices. Despite the recent struggles, all major equity indices remain in positive territory on the year.

Bonds – Bonds Slip into Negative Territory

The third quarter proved quite challenging for bond investors as higher interest rates across the board put downward pressure on bond prices. After starting the quarter around 3.85%, the yield on the 10-year Treasury note finished the third quarter trading around 4.62%. This translated into negative price returns for bond investors with the Bloomberg US Aggregate Index lower by about 3.23% for the quarter. Municipal bonds benefited from tighter spreads earlier this year, but were not immune to higher rates, and the Bloomberg Municipal Index fell by about 4% during the quarter.

Given the recent move higher in rates, both taxable and municipal bond indices dipped slightly into negative territory for the year. The Taxable Bond index is now about 1.21% lower on the year, while the Municipal Index is lower by about 1.38%. Despite the recent volatility, we remain constructive on the outlook for bonds. The chart, right, shows the magnitude of which Treasury Yields have risen since the beginning of last year. As you can see, yields have moved considerably higher, and continue to offer an attractive entry point for investors seeking reliable income or ballast in their portfolios.

Federal Reserve and Inflation

One of the primary drivers behind the most recent tick higher in interest rates has to do with guidance from the Federal Reserve. At the most recent policy-setting meeting in September, the central bank left interest rates unchanged at the current target range of 5.25% - 5.50%. What caught the markets off guard was the Fed’s forward guidance on both inflation and the economy. In the Fed’s last summary of economic projections from June, the FOMC was forecasting a mere 1% growth in real GDP for 2023, with Core PCE inflation projected to finish the year around 3.9%. However, in the most recent projections, the Federal Reserve anticipated economic growth of 2.1% for the year, and core inflation to finish the year around 3.7%. This suggests the economy may not be as close to a recession as the central bank once believed, potentially affording them more leeway to maintain higher rates for longer.

The most recent CPI inflation report for August indicated core inflation continues to move in the right direction, and currently sits at 4.3% on a year-over-year basis. On the other hand, headline inflation is reaccelerating due to higher oil prices, and saw an uptick from 3.2% in July to 3.7% for August. Gasoline prices affect nearly all consumers and play an outsized role in inflation expectations. The central bank has worked diligently to keep inflation expectations anchored around 2%, and any indication they are losing this battle could tip the scales in favor of an additional rate hike in November or December of this year. Furthermore, if consumers begin extrapolating the recent trend higher in energy prices, we may experience a drag on consumer spending, the driving force behind the U.S. economy. As of now, the futures markets are pricing in about a 40% probability of one additional 25 bps rate hike between now and the rest of the year. However, the markets now are pricing in a much lower probability of significant rate cuts for 2024.

Implications of a Government Shutdown

The prospects of a government shutdown in the fourth quarter will likely gather plenty of headlines. At the last minute, the Senate passed a spending bill on Sept. 30 that will allow the government 45 days to finish legislation. While a prolonged period of policy uncertainty could lead to increased market volatility, history tells us past shutdowns tend to be resolved quite quickly with minimal to no impact on markets. Over the last 40 years, the government has experienced a shutdown about every other year, lasting a total of 91 days. This would not be the first shutdown and certainly not the last. Importantly, this deadline does not involve paying the federal debt, which means even if the government is shut, all the debt will get paid on time and there will be no risk of default. For investors, concerns about the government shutdown should not change your long-term investment plan.

Looking Forward: Fourth Quarter

As we look ahead to the final quarter of 2023, we remain cautiously optimistic on the near-term outlook for the economy. We believe a recession will be avoided for the remainder of the year; however, a recession in 2024 still is in the cards, particularly against a backdrop of higher rates.

The bulk of this year’s strong equity performance has been relatively concentrated in a narrow range, with the seven largest stocks dominating returns in the S&P 500. We continue to focus on diversifying our clients’ risk exposures beyond the large cap growth concentration of the S&P 500. Overall, we continue to maintain significant exposure to growth stocks, but are positioned with a bias toward areas of the market with the most compressed relative valuations, which tends to favor value/dividend paying stocks as well as international markets.

Within fixed income, we have been gradually extending duration (buying longer-term bonds) for the better part of 2023. This has taken our clients’ portfolios from a short-duration (more defensive against rising rates) positioning to a more neutral positioning. In the short term, interest-rate movements are difficult to predict; however, we believe interest rates are approaching the peak of this cycle. As a result, we are positioned to take advantage of these higher rates and potentially benefit from lower rates further down the road.

Please let us know if you would like to set up a meeting to discuss any questions about your portfolio.