Q3 2023 Market Perspective
As we reflect on the important developments during the third quarter and prepare our discussion of the near-term prospects for the economy and the markets, we start our communication with a heavy heart. We are monitoring the evolving crisis in Israel and while the ripple effects of this conflict are unknown, Altium is united in its support of Israel.
Both equity and fixed income assets declined during the quarter, with rising interest rates applying pressure to bond prices and equity investors becoming increasingly more concerned about the general state of the U.S. economy and growing geopolitical risks. Equity indices remain positive for the year, but the performance during this latest quarter was consistent with a market that is lacking direction amid elevated uncertainty. Fixed income asset performance has been less predictable and is on the verge of potentially suffering consecutive annual losses, which has never occurred in the post-war era.
Market performance over the past two years, for the most part, tracked the actions and the expectations of the Federal Reserve (Fed). In 2022, a steady dose of aggressive interest rate increases by the Fed and expectations for a U.S. economic recession drove equity and fixed income returns down. Through the first half of 2023 optimism for a soft landing amid a resilient economy and weakening inflation, led to the prospect of Fed interest rate cuts and resulted in a strong rebound across capital markets. However, as we enter the final quarter of 2023, the path of the Fed has been less certain, wavering between raising interest rates and pausing to measure the economic impact of its restrictive policy. As a result, equity prices have remained volatile week to week as new economic data is released. Reports on inflation and the job market, which are key indicators of consumer spending and GDP growth, continue to drive near-term market fluctuations.
A shared view amongst economists is that it takes twelve to eighteen months before monetary policy impacts the economy (the Fed started raising rates in March 2022). While we are beginning to see cracks forming, inflation has not yet returned to acceptable levels for the Fed. The debate continues whether the Fed will keep its foot on the pedal and push the economy into a recession or will the underlying strength of the consumer provide enough support for the economy to avoid a recession despite the Fed’s restrictive policy. We will discuss many of the points in favor of both scenarios in this note, however one thing we see clearly is that being prepared for changing market conditions is a far superior investment strategy to being reactionary. For example, an investment policy statement should clearly outline your investment objectives, which may include both near and long-term cash flow needs, growth requirements and overall risk tolerance, allowing you to comfortably stay committed to your plan during the ebbs and flows of a market cycle.
Q3 MARKET RETURNS
Index Returns [1]:
Major Asset Class Returns
* Source: 2023 Total Return as of 9/30/23, Bloomberg
MARKET HEADLINES AND DATA DEPENDENCY OF THE FED
In September, the Fed decided to maintain the target range for the federal funds rate at 5.25% – 5.50%, after aggressively raising rates 11 times over their previous 12 meetings. Fed chairman Jerome Powell communicated that the answer as to whether or not the Fed has achieved its peak policy rate, or even the possibility of a favored soft landing for the economy, will ultimately come down to data dependency from here on out.[2]
With this in mind, we seek to highlight some notable developments in terms of implications for both monetary policy and the financial markets. In many instances we observe a cause for concern as well as a case for optimism in the headline news and the economic data. We have identified the labor force, the consumer, inflation, fiscal brinksmanship, yields and markets, as key contributors towards making the Fed’s future path far from certain.
LABOR FORCE, CONSUMER & INFLATION
Headlines
Labor Force: The labor market remains tight by historical standards, with the unemployment rate currently at 3.8%. While the U.S. added more than twice the expected jobs in September, gains in wages were more modest. The Fed has been aiming to cool down the labor market, which has helped keep consumer spending strong and the economy growing.[3]
Consumer: Consumers maintain an appetite to spend, currently splurging mostly on food and travel, which correlates to the sticky inflation within the services sector of the economy. However, consumer confidence has started to fall recently, as pressures build behind the rising cost of borrowing, increasing energy costs and the resumption of student debt repayments.
Inflation: Headline inflation accelerated in August, driven by rising oil prices, however, the Fed’s preferred measure of inflation, Core PCE (which excludes food and energy) slowed to a 2.5-year low annual rate of 3.9%. The Fed is strongly committed to returning inflation to its 2% objective.[4]
Implication
Cause for Concern: The Fed stated in its September press release, “Recent indicators suggest that economic activity has been expanding at a solid pace. Job gains have slowed in recent months but remain strong, and the unemployment rate has remained low.” As of early October, updated estimates project a 30% chance of another 0.25% rate hike in 2023, either in November or December. While these estimates have fallen considerably over the past few months, the market is still anticipating higher rates for longer. With the Fed committed to keep interest rates elevated until the data suggest that the economy is slowing, a recession outcome in the U.S. is a high possibility.[2]
Case for Optimism: Since the Fed started raising interest rates, the labor market has gradually softened while inflation has steadily declined in the core goods sector. With Americans running out of excess savings and consumer confidence declining, discretionary spending on core services may soon wane. This could open the door for the data dependent Fed to reduce or remove its restrictive policy before pushing the U.S. into a recession. With U.S. GDP currently expected to grow at low-single digit rates over the next couple of years, a soft-landing scenario (or at worst a shallow recession) remains a possibility, supported in large part by the strength of a resilient labor market.
FISCAL BRINKMANSHIP & ITS IMPACT ON U.S CREDIT RATING
Headlines
In June, a last-minute debt ceiling bill was needed to avert default followed by a midnight deal that was required in September to avoid a government shutdown. The growing political brinksmanship in Washington has caught the attention of the major credit rating agencies. Fitch became the 2nd major U.S. credit rating agency to downgrade U.S. sovereign debt nearly twelve years after S&P did so in August 2011, following the last debt ceiling standoff. The gridlock in Washington was cited as a major driver for the credit revision. In the coming weeks Moody’s has indicated that it could be following suit.
Another major consideration, credit agencies alike are mindful of, is the growing U.S. debt load that surpassed $33T this quarter. While the U.S. Debt-to-GDP ratio is still considered more favorable than many developed nations at 1.2 times, the growing fiscal deficit is a common theme noted amongst credit agencies.
Implication
Cause for Concern: Gridlock in Washington and intensifying political polarization has been commonly cited as a growing risk to the overall credit stability of our country.
Case for Optimism: Despite the gridlock and growing debt burden it is still next to impossible to write-off the significance of the full faith and credit of the U.S. Treasury. Furthermore, both in 2011 when the U.S. credit rating was last downgraded and in late 2018, during the last gov’t shutdown, the markets mostly shrugged off the news as non-events.
FIXED INCOME YIELDS
Headlines
The market continues to price in expectations of interest rates remaining at current restrictive levels for longer than originally anticipated. When looking at yield spreads between the 2 and 10-year Treasury bonds, the yield curve steepened to 59 basis points during Q3. In other words, 10-year yields rose significantly more than 2-year yields. This steeping, or normalization, of the yield curve reflects the rising demand from investors to receive higher yields as compensation to hold longer-term government bonds. While higher rates are good for fixed income investors in the long run, tight financial conditions cast doubt on the sustainability of economic growth in the near-term.
Implication
Cause for Concern: The steepening yield curve implies that the bond market does not expect the Fed to tame inflation and start reducing rates as quickly as previously thought. This is notable as elevated rates raise corporate issuers’ cost of financing debt. Anecdotally, corporate issuers’ proportion of operating income to interest payments (interest coverage ratio) has steadily declined since mid-2022. The prolonged weakening of interest coverage ratios amongst corporate borrowers leaves the prospect of credit quality weakening, spreads widening and increases the risk of corporate defaults, which have in fact recently risen to multi-year highs.
Case for Optimism: Higher rates are beneficial to investors with fixed income investments, resulting in enhanced income. While bonds have recently become increasingly correlated with stock performance (i.e., bond prices declined in the quarter alongside declining stock prices), this should dissipate as interest rates peak and eventually start to decline. In our opinion the steeping yield curve creates a compelling opportunity for investors in short-term investments, such as money markets, to consider adding longer-duration assets. The risk of issuer default on a portfolio can be mitigated through active credit analysis and diversification.
EQUITY & FIXED INCOME MARKETS
Headlines
Equity market breadth was a key focus heading into Q3 and while the lack of breadth began to dissipate early on in July, the positive trend lost momentum along with big-tech market leaders which could not sustain their feverish pace of price appreciation over the first half of the year. The S&P 500 and Nasdaq indices hit intra-year highs in July of over +15% and +30% respectively, though they ended the quarter with two consecutive months of declines. A main driver of August and September’s downturn in stocks were attributed to investors acclimating to the prospect of the Fed maintaining interest rates at restrictive levels for longer.
Fixed income assets were correlated with stock prices during the quarter, as they were in 2022, experiencing low single digit negative returns during the quarter. This has been an unprecedented environment where bonds have extended losses over the past couple of years, with interest rates rising precipitously from the lowest levels in history. Rising rates and persistent inflation are typically bearish ingredients for bonds.
Implication
Cause for Concern: If economic data such as the PCE inflation reading continues to show rising prices of 3%, or more and the Fed is forced to continue to raise rates this would likely pose a negative environment for stocks as well as longer duration assets and bonds. The potential for corporations to suffer declining profitability due to rising costs and/or declining consumer spending further poses risk to bonds in the form of spread widening/diminishing credit quality and would likely negatively impact equity markets.
Case for Optimism: If economic indicators such as employment and GDP continue to signal strength, inflation dissipates, and corporate profit margins can weather the storm, this could potentially set the stage for positive equity markets. Meanwhile, if this scenario were to unfold it would be expected that the Fed would turn more accommodative with its monetary policy which would favor longer duration assets and bonds. The market is currently signaling a nearly 100% chance that the Fed will cut interest rates by 0.25% by its June 2024 meeting.[5]
SUMMARY
With the markets fixated on every word of the Fed, we anticipate heightened levels of volatility as we enter the final months of the year. The data dependency of the Fed makes predicting their next step a frivolous exercise and, in our opinion, makes it even more important to focus on preparing for the range of potential outcomes.
It is important that we reiterate a core tenet of our investment philosophy: That it is best to plan for market volatility and avoid reacting to current market conditions. We plan for this through the creation of your strategic long-term asset allocation, which is developed alongside your personal investment policy statement. For example, if there are short-term cash needs, cash can be invested in high-yielding, short duration assets. Longer-term assets, when allocated appropriately based on your unique circumstance, can remain invested throughout all market cycles.
APPENDIX
Chart A: 2023 Total Return of Major Asset Class Indexes
1 – Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
2 –https://www.federalreserve.gov/monetarypolicy/files/monetary20230920a1.pdf
3 – https://tradingeconomics.com/united-states/unemployment-rate
4 –https://tradingeconomics.com/united-states/core-inflation-rate
5 – Bloomberg data; Census rate expectations
IMPORTANT DISCLOSURE:
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