Market Commentary: Third Quarter, 2023

Capital market volatility picked up during the third quarter as Treasury yields soared to multiyear highs and the equity rally lost momentum. Stubborn inflation, a resilient labor market and a projected ‘higher for longer’ interest rate environment are shifting investor expectations.

The U.S. Treasury yield curve has been inverted for more than 15 months, as measured by the interest rate difference between the two and ten year term maturities. This phenomenon is a very reliable leading indicator of economic weakness, as inverted yield curves have preceded every major economic recession since WWII. That said – not every inverted yield curve has led to a recession, and quite frankly, the economic cycle does not care what any economist is forecasting. To quote John Kenneth Galbraith –

“There are two classes of forecasters: those who don’t know – and those who don’t know they don’t know.”

The yield curve inversion is a consequence of the Fed’s restrictive monetary policy to fight inflation. Although much improved, inflation is not yet close to the Fed’s 2% target. On an annualized basis, August headline and core (net of food and energy) prices increased 3.7% and 4.4%, respectively. Labor demand continues to exceed supply by a wide margin, with near record low unemployment and over 8 million unfilled job openings. It would be unreasonable to expect a pivot in Fed policy with lower interest rates until this relationship becomes more balanced.

In September, the Fed increased its short term interest rate target to 5.25-5.5%, and another 0.25% hike is possible before year-end. Longer term rates are also rising. Since hitting a low of 3.3% in April, the 10-year yield has vaulted to 4.8%. Long term rates have actually moved up faster than shorter term rates, which is having a flattening effect on the shape of the yield curve. This is meaningful – while short term rates have a significant impact on banks and anyone with floating rate debt, long term rates finance most housing and business investment, which will have a more restrictive effect on the economy. Higher interest rates across the yield curve also impact the Federal government, which needs to finance its growing deficits and outstanding debt – even if the Fed holds monetary policy steady. Higher long term rates also reduce the value of future cash flows and puts pressure on stock prices.

As long as the inflation data remains elevated and the unemployment rate low, we should expect current Fed policy to be resolute. As we’ve written in the past, consumers and businesses alike benefitted immensely from the pandemic fiscal and monetary stimulus that caused this inflationary cycle. Today, most leverage is long term and fixed rate, which buffers many borrowers from the full effect of higher interest rates. The longer interest rates remain restrictive however, the more impactful they become. Net savers and investors on the other hand, are enjoying the highest yields on fixed income securities in over 15 years.

Domestic equity performance, as measured by the S&P 500 index, returned -3.3%, +13.1% and +21.6% for the trailing quarter, year to date and 1-year periods. Market leadership continues to be very narrow, with the majority of index returns attributed to large cap growth companies. Despite a slight pull back in market prices during the third quarter, valuations remain above historical averages, at 17.8x forward earnings. It is noteworthy, that according to analysts’ estimates, S&P 500 index earnings are expected to grow by 12% this year and by double digits again in 2024 and 2025. These estimates are much higher than the 8.4% historical growth rate during the last twenty years. In our view, these are very optimistic estimates, without an objective assessment of economic conditions, current monetary policy or the cyclical nature of economies. We expect actual earnings may be lower than currently projected.

Developed international equity markets, as measured by the MSCI EAFE index, returned -4.1%, +7.1% and +25.7% for the trailing quarter, year to date and 1-year periods. The rally in foreign equities has been broad based, with positive returns from large and small cap companies, and value and growth styles. Developed International equity has cumulatively outperformed domestic equity by a small amount over the trailing seven quarters (+0.30%). Geopolitical and currency risks are ever present when investing abroad, but despite these risks, foreign equity outperformance may continue due to relative valuations and mean reversion. Developed International equities are currently valued at just 12x forward earnings, a 30% discount to the forward earnings multiple of domestic equities.

Recessions rarely occur when the economy is at full employment as it is today. Cycles are fundamental to markets and the Fed’s restrictive policy stance is prioritizing the fight against inflation over economic growth – which makes the economy vulnerable. Eventually short term rates will decline, but could remain elevated for a period of time or even move higher from here before declining – we will not know without the benefit of hindsight. Once interest rates do peak, longer term bonds and equities will likely outperform short term investments such as Treasury bills and CDs. Note the chart below, illustrating forward 12-month returns following peak rates in each of the last six interest rate cycles.

With interest rates now exceeding inflation, fixed income offers positive real yields. On a risk adjusted basis, expected fixed income returns are at the best levels since 2007. That said, there is always an opportunity cost in capital markets – investments which may enhance returns in the short term are often at the cost of better returns over the long term. Time amplifies the difference between short and long term strategies, with long term allocations compounding for better results. The current investment landscape is not exempt from this guiding principle.

These are some of the many reasons we do not attempt to time capital market responses to the economic cycle – it is far more constructive to manage liquidity needs responsibly and otherwise remain fully invested, consistent with risk tolerance, goals and objectives.

We are grateful for your trust and confidence. If you would like to review your financial plan or investment portfolio please do not hesitate to reach out to us. We welcome your questions and will be responsive.