Third Quarter 2023 Investment Commentary
After a strong first half to 2023, global equity markets declined in the third quarter. The S&P 500 Index reached a 2023 high at the end of July, but from its intra-quarter high the index declined 6.3% through the end of September. This was the second meaningful decline this year; the S&P 500 fell 7.5% in February and March during the regional banking failures. Despite the decline, the index is still up 13.1% year to date.
Small-cap stocks also had momentum early in the quarter but changed course and ended the quarter down 5.1%. Year-to-date, small-cap stocks are still up 2.5% but meaningfully trail large-caps.
With virtually all segments of the stock market posting gains this year through September, one might think that we’re in the midst of a broad-based rally. However, stock gains have remained unusually narrow, with the largest stocks in the index leading the way. The standout performers are those sectors with the largest stocks, while most other sectors have been relatively flat. Consumer discretionary has been driven higher by a 51% gain from Amazon.com and a 103% return from Tesla. The information technology sector has outperformed thanks to Apple (32%), Microsoft (33%) and NVIDIA (198%). Communication services have been propelled higher by a 48% return for Alphabet and 149% from Meta Platforms. These seven stocks make up the “Magnificent Seven” that account for the majority of year-to-date returns of the S&P 500. Further illustrating the market-cap effect, the equal-weighted S&P 500 index is roughly flat this year through September.
Within foreign markets, developed international stocks declined 4.1% in the quarter and are up roughly 7.1% year-to-date. Emerging-markets stocks fell 2.9% in the quarter and are up 1.8% this year through September. The U.S. dollar surged over 3% during the quarter, resulting in a headwind for foreign markets.
Moving to the fixed-income market, core bonds fell 3.2% in the quarter as the interest rate rose. The benchmark 10-year Treasury yield climbed nearly 70bps in the quarter, ending the period with a 4.59% yield, the highest level since 2007. High-yield bonds managed to eke out a small quarterly gain and are up 6% for the year-to-date period.
Portfolio Performance and Key Performance Drivers
Strategy and benchmark returns were negative during the quarter—as most major asset classes posted losses. Both global stocks and U.S. core bonds lost more than 3% in value last quarter. Our more conservative models outperformed their benchmarks, while models with higher equity exposure underperformed.
Our overall fixed-income allocation added value during the quarter. Our fixed-income allocation benefited from positions in flexible, actively managed bond funds, which collectively posted modest gains in the quarter. These funds generally benefited from being less interest-rate sensitive and owning higher yielding securities compared to core bonds. Active core bond positions were negative in the period but finished the quarter ahead of the Bloomberg U.S. Aggregate Bond Index.
The active equity managers we use, in aggregate, underperformed their indexes during the quarter. Overall large-cap value and growth managers outperformed. While core equity and international managers lagged their respective benchmarks.
For the year-to-date period, our portfolios remain in line with their benchmarks. Through the first three quarters, our active managers (both stocks and bonds) have added value. Our active fixed-income bond funds have had the biggest positive impact—as most funds have been able to outpace the Bloomberg U.S. Aggregate Bond Index’s year-to-date loss. Active U.S. large-cap funds have, in aggregate, outperformed the S&P 500 thanks to strong gains from growth managers (16% to 32% compared to a 13.1% return for the S&P 500).
Macro Outlook for the Next 6-12 Months
As was the case last quarter, the big questions remain whether we will have a soft landing or a hard landing, and the timing. It goes without saying that the answer will likely lead to meaningfully different market outcomes. If the Fed can manage to guide the economy to a soft landing, we would expect to see the market’s gains broaden out beyond the large-cap technology-related sectors. Conversely, a hard landing would lead to broader-based declines.
There are reasons to be cautious. We have seen one of the quickest and sharpest tightening cycles in history, and lending standards have tightened considerably. Both factors create recessionary conditions, particularly as the Fed has a history of raising rates too far.
We have already seen some negative impacts of rapidly rising rates. Earlier this year, higher rates played a key role in the regional bank failures, which led to a drying up of liquidity in the real estate sector, pushing property values sharply lower. We have also seen corporate earnings decline, and as a result, there has been an increase in bankruptcies, particularly among non-public, loan-only issuers that were already struggling. On the consumer front, there is some evidence that low-income consumers are facing stress, while middle-income consumers are becoming increasingly reliant on credit card debt.
With tighter money and credit conditions, it’s likely that the impact of higher rates is just beginning, and we expect it will be a drag on consumers and corporations. Higher rates should result in less spending, which eats into consumption. It’s also possible, if not likely, that bank lending will remain constrained in the near to intermediate term, further slowing growth.
With the Fed in inflation-fighting mode, and interest rates high, there is an increased likelihood of a recession, particularly if rates nudge even higher and remain elevated. There are many market indicators that support a recessionary case. The Treasury yield curve has been and remains steeply inverted, and this has historically been a good (but not bulletproof) predictor of recession. The Conference Board’s Leading Economic Index (LEI) fell again in August. The LEI index has now declined for nearly a year and a half straight, indicating the economy is heading into a challenging growth period and possible recession over the next year. Meanwhile, there is some clear evidence that the tighter monetary policy is impacting the housing market and lending conditions, which impacts business investment.
A perhaps counterintuitive point is that because this recession has been so widely anticipated for so long now, it may actually reduce the risk of a deep recession. According to New York Federal Reserve data, there has been a 60% chance of recession occurring in the next twelve months. (See chart below.) Historically, probabilities at these levels are associated with recessions. And going back to late 2022 and early 2023, the press termed this the “most-anticipated recession ever.” Amid all this built-up anticipation, some companies, especially tech have laid off workers and slowed hiring. These corporate moves help to loosen the labor market and potentially ease inflation pressures.
What about Inflation?
Inflation has come down meaningfully from its June 2022 high of 9.1%, thanks in part to the Federal Reserve’s rapid rate hikes. At this point, it is clear the rate-hike regime is close to an end. In late September, the Federal Reserve maintained the target range for the federal funds rate at a 22-year high of 5.25%-5.5%, following a 25bps hike in July. The September pause was in line with market expectations. But Fed Chair Powell signaled there could be another hike this year saying that the FOMC cannot allow inflation to get entrenched in the U.S. economy, and they will do what it takes to get it down to their target of 2% over time. The most recent year-over-year inflation number was 3.7%, almost twice the Fed’s long-term target. Projections released in the Fed’s dot plot showed the likelihood of one more 25bps increase at the November 1 meeting, then two cuts in 2024.
While the Fed continues to be concerned about inflation, there are signs that the effects of Fed policy are working their way through the system. We believe that the Fed has gotten the upper hand on inflation and that the remarkable impact that the pandemic had on prices due to supply shortages and the dramatic shift in consumer behavior is clearly over.
While there are a variety of opinions around inflation, it seems clear that one driver was the massive amount of money supply growth that started in early 2020. Pandemic-related stimulus payments were in the trillions. The chart below shows the dramatic increase in Money Supply (or M2) that occurred. Arguably, the supply chain issues and the flood of money that went into the economy is what pushed inflation to unexpected levels. If we compare the year-over-year money growth to year-over-year core CPI, one could surmise that inflation is a lagging indicator and inflation could continue to decline from current levels.
Financial Markets Outlook for 2023 and Beyond
The aggressive hiking cycle that started roughly 18 months ago was finally put on pause in late July—although one more 25 basis point hike could still happen. Since March 2022, the Federal Reserve increased rates from zero to a target level of 5.25%-5.5%. Around the same time that the Fed hiked for what might be the final time in this cycle, the S&P 500 also hit an intra-year high and started to decline. Since the end of July, the S&P 500 has fallen 6.3%. The Index remains up a solid 13.1% so far this year—defying many expectations in what was widely anticipated to be a year in which the economy hit the skids.
As noted earlier, despite stalling over the third quarter, the year-to-date outperformance of the seven largest stocks in the S&P 500 continues to explain most of the U.S. equity returns. These “magnificent seven” have increased more than 80% this year. The other 493 stocks are basically flat. Given those figures, it is unsurprising to see a record low percentage of S&P 500 stocks outperforming the Index. Ned Davis Research data shows just 28% of S&P 500 constituents have a return better than the 13.1% index return this year.
Last year S&P 500 profits (GAAP) fell by nearly 13%. The consensus going into 2023 was for a recession and that profits would likely fall further in that scenario. With the recession having been avoided (for now), profits are showing signs of troughing. Should the current consensus numbers for the third quarter be accurate, earnings will be flat year-over-year. And the fourth quarter has the potential for year-over-year growth in the double-digit range.
Better than expected profit growth in recent quarters has been bolstered by strong revenue growth. S&P 500 sales are growing at a double-digit pace thanks to a stronger than expected consumer and price increases that are still being pushed through. Profit margins have fallen back to 10%, which was where they stood prior in 2019. But despite lower margins, companies can continue to decent earnings growth if revenues remain robust. Not until there is a recession will revenues and GDP take a hit.
Today, inflation remains elevated but on a clear path downwards. However, the S&P 500’s current drawdown that started right around the day of the (potentially) final rate hike could be a sign that equity markets are finally starting to believe the Fed’s “higher for longer” mantra.
International and Emerging-Markets Stocks
The appreciating U.S. dollar has been a significant deterrent for international stocks (see chart below). In the current regime of U.S. dollar strength that started in 2011, U.S. stocks have significantly outperformed foreign stocks. There was a short reprieve from dollar strength from 2017 into early 2018, during which European stocks outperformed by nearly four percentage points and emerging-market stocks did nearly 20 percentage points better. When the dollar declines again, we would expect foreign equities to outperform—much like in other cycles over the past 50 years.
While U.S. earnings are potentially troughing—or, at a minimum, the rate of decline slowing—earnings overseas are at different points. Earnings in Europe remain close to cycle highs despite a stagnant German economy. Emerging markets, on the other hand, have seen their earnings fall roughly 17% from their high in early 2022. China has struggled to meaningfully reignite its economy, and consequently, earnings have not moved much higher from their cycle lows. Given China’s weight in the broader index (roughly 30% of MSCI EM), their sluggish earnings continue to weigh on index level earnings.
The Chinese stock market has bounced higher from its lows almost one year ago. However, Chinese stocks remain more than 50% lower than where they stood in early 2021. Since 2021, China has experienced a number of rolling crisis’s—from their property bubble to regulatory crackdowns on for-profit education and technology companies to a zero-COVID policy that lasted into late 2022. The government has resisted their old stimulus playbook of showering money into capital intensive investments. Instead, Chinese officials have used targeted easing policies, such as lowering key interest rates. As China moves away from investment-led economic growth, there will be a high bar for the government to undertake the same level of stimulus as in years past.
Inflation and Fed policy will continue to be major drivers of bond market returns. For now, investors continue to benefit from today’s higher yields and an inverted yield curve. Despite higher short terms rates, we continue to maintain some exposure to the longer end of the curve with core bonds. The Bloomberg U.S. Aggregate Bond Index is currently yielding 5.4%, which is above the current 3.7% inflation level. So, bonds are finally providing a positive real (after-inflation) yield. We also continue to hold core bonds as a ballast to balanced portfolios, as we believe they will likely provide some downside protection in the event of a recession.
We continue to be positive about corporate bonds. Overall, credit fundamentals are still holding up despite higher debt costs. Interest coverage, the level of leverage, and cash levels all look better than in historical periods heading into a recession. In addition to core bonds, we continue to have meaningful exposure to higher-yielding, actively managed, flexible bond funds run by experienced teams with broad opportunity sets. There are several fixed-income sectors outside of the traditional parts of the bond market that provide attractive risk-return potential, and we access them through active managers. Some of these funds are currently yielding in the high single digits, while maintaining an eye on capital preservation.
As we look ahead, a mild recession is still our best case looking out to 2024. Of course, the timing and magnitude of the Fed’s response to economic data will be critical to the outcome. Currently, the Fed is signaling 50 basis points of rate cuts in 2024, but it’s quite possible that they will cut more meaningfully. Therefore, we can’t rule out the possibility that the Fed does thread the economic needle and successfully guides us to the rare soft landing. Given the uncertainty, we expect volatility, and we think that it will be more critical than ever to keep our pencils sharp and be ready to take advantage of market dislocations. This is not to suggest that we are changing our stripes as long-term investors. We continue to believe that taking a disciplined long-term view is the path to successful investing. We will maintain a balance of offense and defense, seeking attractive risk-reward opportunities that are supported by thorough analysis. We thank you for your continued confidence.
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