2023 3rd Quarter Market Commentary
Top Headline for Q3: “Higher for Longer” Finally Hits Markets
Equity and bond markets took a “bearish” turn in Q3. Markets had been ignoring the “higher for longer” calls from the Federal Reserve Bank (“Fed”), but that changed abruptly in Q3. Market participants finally capitulated to the Fed and “repriced” to new rate expectations. For example, at the start of 2023, market participants were still considering the possibility of a Federal Funds Rate reduction in 2023 and were expecting at least four reductions in 2024. However, by the end of Q3, the market was pricing roughly a 50% chance of an additional rate increase in November of 2023 and only 2 reductions in 2024 – a dramatic shift in expectations.
Market price movements can largely be explained through these changes in expectations as reflected in the treasury bond yield curve. For example, the 10-Year treasury bond yield rose approximately 80 basis points in Q3 – a massive move with immediate adverse consequences. As expected, bond markets felt the pain with long-dated bond indices reaching double digit declines. Moreover, the stock market started to feel the pinch with nearly all sectors negative for the quarter.
General Market Update
US Equities: During Q3, the market cap weighted S&P 500 Index fell 3.7%, the equal weighted S&P 500 fell 4.9%, the Nasdaq Composite dropped 4.1%, and the small company Russell 2000 Index fell 5.5%. Nearly all sectors tumbled during the quarter with the energy sector (XLE) being the one bright spot – rising 12.2% as higher oil prices pushed up stock values. It’s interesting to note that the “tech” outperformance that explained the year-to-date gains through Q2 persisted through Q3, but to a lesser extent (i.e., the tech leaders have yet to give back much of their recent outperformance). A few of the big losers in Q3 were high dividend “income” sectors including utilities and REITs, which appear to be losing investors to very attractive short-term treasury bonds and money market yields.
International and Emerging Market Equities: International equity markets also performed poorly during the quarter. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was down 4.7%, and the Schwab Emerging Markets ETF (SCHE) was down 2.8%. The pain may not be quite over in Europe as the European Central Bank and Bank of England also maintained a “hawkish” rhetoric with more rate hikes possible.
Fixed Income and Credit: As mentioned above, Q3 was a very rough quarter for fixed-income investments with long maturities (i.e., high “duration” risk). Q3 saw the unusual circumstance of having the “long end” of the yield curve rise following a Fed increase in the Federal Funds Rate. Normally, a rise in the Federal Funds rate would curtail the economy and cause growth expectations to fall leading longer-term rates to decline. It’s clear that the market is not convinced that inflation is fully under control. It seems that the lingering issues are (1) uncertain residual effects from the massive COVID cash stimulus and (2) questions related to the Federal Budget deficit and lack of fiscal austerity.
Commodities, Precious Metals, Inflation: The data shows that inflation continues to fall globally. Moreover, central banks in Europe and North America seem committed to bringing it back down to the 2% target rate. However, investors are generally concerned that fiscal policy lacks austerity. We are running massive deficits and increasing the money supply, which is inherently an inflationary activity. The activity runs counter to the Fed’s inflation-reduction efforts. As such, we remain supportive of pro-inflation assets as a hedge against currency devaluation and above-trend inflation.
A Look Ahead
With the capitulation from market participants regarding the Federal Funds Rate expectations, bond markets have de-risked to some degree. In other words, it’s getting harder to imagine a greater degree of pessimism regarding future Fed policy. Our view is that it may be an opportunity to begin adding some longer-dated bond exposure to portfolios.
The equity market remains more challenging. On a positive note, any reduction in tightening, perceived or actual, would likely buoy stocks higher. In fact, certain beaten-down sectors like REITs and utilities would likely move sharply higher. However, if the Fed sticks to “higher for longer” (e.g., raises further and/or holds rates at current levels deep into 2024) it’s likely to cause slow and steady damage to certain sectors of the stock market. Most notably, unprofitable small caps look particularly vulnerable. While estimates vary, some analysts calculate that as much as 1/3 of the Russell 2000 small cap index are “zombies” (i.e., they earn less than they pay in interest payments). These companies will face substantial headwinds as bonds mature and need to be re-issued at much higher rates. Overall, it’s an environment that calls for a tactical approach in the equity market, and we look forward to trying to take advantage of these opportunities.