Q3 2023 Market Highlights: US Equity & Fixed Income Review, Inflation, Fed Policy, and Outlook. Discover key insights into market performance, treasury yields, inflation trends, and the Federal Reserve's stance. Get a comprehensive analysis of the US economy and both short-term and long-term market outlooks
» US Equity Markets: The market declined in the third quarter as the S&P 500 decreased by -3.3%, but after increasing by +16.9% in the first half of 2023, the year-to-date gain is still +13.1%. The market reached its high point for the year on July 31st but declined by -6% through the end of the quarter. The S&P 500 is now higher by about 22% from the bear market low reached on October 12, 2022, when the market fell by -24.5% from peak-to-trough.
» US Fixed Income Market: The Bloomberg US Aggregate Bond index (Agg), which acts as a proxy for the intermediate-term investment-grade bond market, decreased by -3.2% in the third quarter as the 10-Year Treasury yield increased to 4.58% in the period (bond prices move inversely to interest rates and credit spreads). The bond market has now declined by -1.2% in 2023. The yield to maturity on the US Aggregate Bond index was 5.4% at the end of the quarter, which is the highest level since 2008.
» Treasury Yields: Yields increased across the Treasury curve. The 2-Year Treasury increased from 4.88% to 5.05% and the 10-Year rose from 3.84% to 4.58% during the quarter. Interest rates moved higher due to the economy performing better than expected, still-elevated inflation, higher oil prices, a renewed focus on the country’s debt and deficit problem, and the Fed’s new “higher-for-longer” outlook combined with their quantitative tightening program.
» Inflation: Most inflation readings have decelerated from peak levels with several indicators returning to normalized ranges. While the Fed acknowledges overall progress, they are not pleased with the pace of disinflation in the services sector as measured by the Core Personal Consumption Expenditure (PCE) Index. The latest Core PCE Inflation reading of +3.9% is still well above the Fed’s 2.0% target.
» The Fed: The FOMC raised the federal funds rate 25 basis points (0.25%) at their July meeting before pausing rate hikes in September. The top end of the federal funds rate now stands at 5.50%. Since March of 2022, the Fed has increased interest rates by 5.25% total for one of the quickest tightening cycles in United States history. The FOMC’s most recent Summary of Economic Projections (SEP) showed that the median participant expects one more rate hike this year before they cut rates by 50 basis points (0.50%) to 5.1% in 2024.
» US Economy: The resiliency of the economy this year has surprised many observers, including us. Even the Fed is taking a more optimistic view and is no longer forecasting a recession in 2023. The perceived odds of a soft-landing, where the economy avoids a recession while inflation decelerates toward the Fed’s 2% target, have increased. Real GDP growth for 2023 is now estimated at +2.0%, compared with a forecast of +0.3% at the start of the year.
» Short-Term Market Outlook: Over the summer, we wrote that we were turning cautious after the market broke above its 14-month trading range of 3,600 to 4,300 and headed toward 4,600. Given our cautious view at the time, many of our actively managed portfolios shifted defensively in July and August through a decrease in overall equity exposure. Now that our cautious view has been validated and the market has pulled back into its old trading range, we have upgraded our near-term view to balanced. Although, we are expecting more volatility and for the market to remain rangebound a while longer. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
» Long-Term Market Outlook: In our view, investors with a globally diversified portfolio and a long-term horizon should continue to remain optimistic. Markets have historically increased over time despite frequent drawdowns as successful corporations have been able to figure out ways to generate profits through advances in innovation and productivity. To capitalize on the power of compounding, we believe in the benefits of staying Disciplined, Opportunistic, and Diversified, while Mitigating fees, taxes, and expenses. In our opinion, adhering to a structured process and executing on all these components should help keep our clients on track toward pursuing their long-term objectives. Historically, equity markets have recovered from recessions and downturns. Past performance is no guarantee of future returns. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Please see some of our most recent market commentaries:
The market declined in the third quarter as the S&P 500 decreased by -3.3%, but after increasing by +16.9% in the first half of 2023, the year-to-date gain is still +13.1%. The market reached its high point for the year on July 31st but declined by -6% through the end of the quarter. The S&P 500 is now higher by about 22% from the bear market low reached on October 12, 2022, when the market fell by -24.5% from peak-to-trough. Although the market has had solid performance for nearly the last twelve months, the S&P is still -8% below its all-time high on a total-return basis.
We constantly remind our clients to maintain a long-term viewpoint as markets can be incredibly volatile over the short-term. The stock market has historically gone up over time, but returns are not linear. Since 1928, the S&P 500 has generated a total annualized return of +9.5% despite an average peak-to-trough decline of -15% at some point each year. Market performance over the last two years reinforces our belief in a long-term viewpoint. As noted in our S&P 500 Bear Markets chart, historically challenging environments have created strong buying opportunities for long-term investors. Historically, equity markets have recovered from recessions and downturns. Past performance is no guarantee of future returns. Consider your own risk tolerance, financial circumstances, and time horizon.
The market rally since October was driven by evidence of disinflation, the economy, labor market, and corporate earnings holding up better than expected, and the perceived benefit that artificial intelligence (AI) will have on profits and productivity. The weakness in the third quarter was caused by fears over rising interest rates and the Fed’s “higher-for-longer” outlook. Please see our Client Question: Why do Interest Rates Impact Stock Prices?
Source: Bloomberg
Size / Style / Sector
Size: Large Caps (S&P 500: -3.3%) outperformed Mid (S&P 400: -4.2%) and Small (Russell 2000: -5.1%).
Sector: Only two of eleven sectors were positive in the third quarter. Energy (+12.2%) was the top performer as the price of WTI crude oil increased by 29% to $91 per barrel. Interest rate sensitive sectors, including Real Estate (-8.9%) and Utilities (-9.3%), were the laggards.
The three worst performing sectors of 2022 are still the top performers this year: Consumer Discretionary (26.6%), Technology (34.7%), and Communication Services (40.4%). Note that these three sectors are the home for the Magnificent 7 stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms), which are still responsible for most of the S&P 500’s gain this year despite mixed results in the quarter. The market often undergoes these violent rotations that can make an under-diversified investor feel like a genius one day and a fool the next. Rather than make risky concentrated bets, we prefer to construct diversified portfolios across regions, countries, market caps, factors, styles, sectors, and industries and tilt toward the areas we feel provide the most potential benefit.
Source: Bloomberg
US FIXED INCOME MARKETS
Interest Rates
Yields increased across the Treasury curve. The 2-Year Treasury increased from 4.88% to 5.05% and the 10-Year rose from 3.84% to 4.58% during the quarter. Interest rates moved higher due to the economy performing better than expected, still-elevated inflation, higher oil prices, a renewed focus on the country’s debt and deficit problem, and the Fed’s new “higher-for-longer” outlook combined with their quantitative tightening program.
Fixed Income Objective
As part of diversified portfolios, we purchase bonds with various types, issuers, maturities, and credit ratings. Our objective with fixed income is to pursue ballast, stability, and income in portfolios. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Ballast: bonds that have a low or negative correlation to equities. Ideally, the fixed income holdings are increasing when equity markets are declining. Typically, intermediate- and long-term bonds with high credit ratings provide the most ballast.
Stability: created by investing in bonds with low price volatility no matter the macroeconomic environment. High quality short-term bonds have lower volatility than most asset classes.
Income: fixed income should provide a predictable stream of income to portfolios. We generally try to optimize income without taking on unnecessary credit risk or volatility.
Please see our Client Question: Bond Primer where we detail bond mechanics, characteristics, types, risks, and historical returns.
Short-Term Bonds
Short-term bonds have closer maturities and are consequently less interest rate sensitive than intermediate- or long-term fixed income securities. Pursuing stability and income from short-term bonds, including Treasuries, has been a successful strategy as yields remain elevated. Short-term Treasury yields, including, the 3-Month (5.5%), 6-Month (5.5%), and 12-Month (5.4%) are at their highest levels since the early 2000s. Once the Fed starts cutting the federal funds rate, short-term Treasury yields should also decline. We don’t expect +5% short-term yields to be around forever, but we are opportunistically enjoying them while they last. If interested, please speak with your advisor about our Cash Alternatives Strategy, which is an investment strategy designed for individuals or entities to invest excess cash seeking potentially attractive yields in a conservative portfolio of short-term fixed income, including US Treasuries. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Investing involves risk including loss of principal. This strategy and its related holdings are not FDIC-insured.
Intermediate-Term Bonds
The Bloomberg US Aggregate Bond index (Agg), which acts as a proxy for the intermediate-term investment-grade bond market, decreased by -3.2% in the third quarter as the 10-Year Treasury yield increased to 4.58% in the period (bond prices move inversely to interest rates and credit spreads). The bond market has now declined by -1.2% in 2023. The last two-plus years have been frustrating for intermediate-term fixed income investors as bonds have provided negative returns without any ballast. Since September 1, 2021, the Agg bond index has decreased by about -15% as the 10-Year Treasury yield has increased by nearly 330 basis points (3.3%).
Does this mean that it’s time to throw in the towel and abandon intermediate-term bonds as part of a diversified investment portfolio? No, not in our view. All else equal, we expect intermediate-term bonds to provide both ballast and positive returns in the future once yields stabilize. For both new investors and those that have ridden out the last two years, the good news is that the yield to maturity on the US Aggregate Bond index is now 5.4%, the highest level since 2008. Yield to maturity is defined as the estimated annualized rate of return an investor can expect on a bond if purchased today and held to maturity, assuming the issuer makes all their interest and principal payments (i.e., no defaults). In other words, expected future returns from the Agg bond index have not been this attractive in 15 years. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Source: Bloomberg
Inflation
The increase in inflation since early-2021 was driven by supply chain bottlenecks, surging energy prices, strong consumer demand caused by a solid labor market, and massive amounts of stimulus. Most inflation readings have decelerated from peak levels with several indicators returning to normalized ranges. While the Fed acknowledges overall progress, they are not pleased with the pace of disinflation in the services sector as measured by the Core Personal Consumption Expenditure (PCE) Index. The latest Core PCE Inflation reading of +3.9% is still well above the Fed’s 2.0% target.
The Fed has divided inflation into three buckets: goods (decelerating as supply chains normalize), housing (decelerating under rising mortgage rates and just starting to show up in the data), and non-housing related core services (still elevated due to the strong labor market and robust wage growth). The Fed theorizes the best way to decrease services inflation is to lower demand by weakening the labor market and aggregate spending.
The Fed’s latest Summary of Economic Projections show the median participant expects Core PCE Inflation to fall to 3.7% in 2023, 2.6% in 2024, and 2.3% in 2025. Note that the Fed still shows inflation above their 2% target by the end of 2025.
Here are several key inflation indicators and a chart tracking the data since the start of 2020:
• The Bureau of Labor Statistics Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The index includes food and energy prices.
o Latest Reading: 3.7% (August). Peak: 9.1% (June 2022).
• The Core Personal Consumption Expenditure (PCE) Index measures the prices paid by consumers for goods and services based on surveys of what businesses are selling. Core means that the index excludes food and energy prices. This is the Fed’s preferred inflation measure, which they target at an average of 2%.
o Latest Reading: 3.9% (August). Peak: 5.4% (February 2022).
• The Core Producer Price Index (PPI) measures the average change in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.
o Latest Reading: 2.2% (August). Peak: 9.7% (March 2022).
• The Bureau of Labor Statistics Average Hourly Earnings tracks total hourly renumeration (in cash or in kind) paid to employees in return for work done (or paid leave). Data is from the Current Employment Statistics (CES) survey.
o Latest Reading: 4.3% (August). Peak: 8.1% (April 2020).
• The University of Michigan Inflation Expectations data is based on a monthly survey designed to gauge consumer expectations. Participants are asked for their view on annual inflation over the next 5 to 10 years.
o Latest Reading: 2.8% (September). Peak: 3.1% (January 2022).
Source: Bloomberg
The Fed
The Federal Reserve serves as the central bank of the United States and performs key functions designed to promote the health of the economy and stability of the financial system. The three key entities include the Board of Governors, twelve Federal Reserve Banks, and the Federal Open Market Committee (FOMC). The FOMC sets monetary policy in accordance with its mandate from Congress: to promote maximum employment, stable prices, and moderate long-term interest rates. According to the Fed, “monetary policy directly affects interest rates; it indirectly affects stock prices, wealth, and currency exchange rates. Through these channels, monetary policy influences spending, investment, production, employment, and inflation in the United States.” Please see our Client Question on The Fed which details the key entities, and the impact monetary policy has on the economy, interest rates, and stock prices.
Source: Bloomberg
Interest Rates: The FOMC raised the federal funds rate 25 basis points (0.25%) at their July meeting before pausing rate hikes in September. The top end of the federal funds rate now stands at 5.50%. Since March of 2022, the Fed has increased interest rates by 5.25% total for one of the quickest tightening cycles in United States history. The FOMC’s most recent Summary of Economic Projections (SEP) showed that the median participant expects one more rate hike this year before they cut rates by 50 basis points to 5.1% in 2024. The market is currently pricing in about a 50% chance that the Fed will raise rates again this year and agrees with 50 basis points of cuts in 2024.
Balance Sheet – Quantitative Tightening: The Fed is also reducing the size of their nearly $9 trillion balance sheet. The runoff plan is for monthly caps of about $60 billion for Treasuries and $35 billion for agency mortgage-backed securities. The monthly reduction of about $95 billion is larger than the $50 billion per month pace that was used during the 2017-2019 runoff plan. At the current runoff rate, it will take over 4 years for the Fed’s balance sheet to decrease to its pre-pandemic size.
“Looking ahead, we are in a position to proceed carefully in determining the extent of additional policy firming that may be appropriate. Our decisions will be based on our ongoing assessments of the incoming data and the evolving outlook and risks.” – Fed Chair Jerome Powell
The Fed is getting ready to turn the page from focusing on how high to raise interest rates to concentrating on how long they should keep rates elevated. Recent speeches from committee members as well as the latest SEP indicate the Fed is forecasting that interest rates will remain “higher-for-longer.” Currently, both the Fed and market pricing expect the federal funds rate to be at 5.1% at the end of 2024. We monitor Fed projections and market pricing closely, but we also recognize that these estimates are only a snapshot in time and will change rapidly as economic data evolves.
How long rates stay elevated will ultimately be a function of how quickly inflation growth declines. The Fed won’t be ready to think about cutting interest rates from present levels until Core PCE Inflation, currently at 3.9%, decelerates further. The reading likely needs to approach 3% to give the Fed enough confidence that inflation is on a sustained downward trajectory to the 2.0% target. Once inflation is contained, the Fed will begin to lower interest rates and ease their foot off the monetary policy brake pedal.
Source: Bloomberg
US Economy
The resiliency of the economy this year has surprised many observers, including us. Even the Fed is taking a more optimistic view and is no longer forecasting a recession in 2023. The perceived odds of a soft-landing, where the economy avoids a recession while inflation decelerates toward the Fed’s 2% target, have increased. Real GDP growth for 2023 is now estimated at +2.1%, compared with a forecast of +0.3% at the start of the year.
While we have been pleased with how the economy has performed, there are still reasons for caution. Several recessionary indicators are still flashing yellow or red, including the inverted yield curve, leading economic indicators, and the ISM Manufacturing survey. The economy has been supported by a strong labor market and robust spending, although now there is evidence that the consumer may be running low on purchasing power. Furthermore, the lagged effect of tighter monetary policy, rising oil prices, the United Auto Workers strike, and the resumption of student loan payments will all weigh on near-term economic activity.
We’re taking a wait-and-see approach as the post-pandemic economy has thrown a series of head fakes. At times a recession seemed imminent and at other times we watched as the labor market set new records. We continue to believe that the key to economic growth in 2023 and 2024 is for inflation to become contained so the Fed can stop their tightening cycle before higher interest rates eventually lead to cracks in the labor market and/or the broader economy. Please see our latest data on US Recessions and S&P 500 Performance.
Source: Winthrop Wealth, Bloomberg
Source: Bloomberg
Outlook
Source: Winthrop Wealth, Bloomberg
We continue to separate our outlook into short- (months) and long-term (years) periods.
Short-Term: Our near-term view is now balanced after the S&P 500 experienced a -6% pullback from July 31st through the end of the quarter. Over the summer, we wrote that we were turning cautious after the market broke above its 14-month trading range of 3,600 to 4,300 and headed toward 4,600. We expected some consolidation after the strong year-to-date performance and stated that a move back down into the upper end of the recent trading range was a probable outcome. Given our cautious view at the time, many of our actively managed portfolios shifted defensively in July and August through a decrease in overall equity and less exposure to certain mega cap stocks that have had massive gains this year. Now that our cautious view has been validated and the market has pulled back into its old trading range, we have upgraded our near-term view to balanced. Although, we are expecting more volatility and for the market to remain rangebound a while longer. We would turn more optimistic as inflation dissipates, the Fed stops their tightening campaign, and fundamentals improve. We would turn more cautious or pessimistic if the market were to break toward all-time highs without fundamental support, if inflation reaccelerates, or interest rates keep marching higher. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
• Long-term: In our view, investors with a globally diversified portfolio and a long-term time horizon should continue to remain optimistic. Markets have historically increased over time despite frequent drawdowns as successful corporations have been able to figure out ways to generate profits through advances in innovation and productivity. To capitalize on the power of compounding, we believe in the benefits of staying Disciplined, Opportunistic, and Diversified, while striving to Mitigate fees, taxes, and expenses.
• Disciplined: consistently applying our investment process and philosophy, which are grounded in a long-term approach. • Opportunistic: rebalancing, repositioning, and tax-loss harvesting to take advantage of market volatility and dislocations. • Diversified: seeking to ensure that portfolios are properly allocated across and among asset classes to enhance consistency. • Mitigate: striving to avoid unnecessary disbursements, including fees, taxes, and expenses.
In our opinion, adhering to a structured process and executing on all these components should help keep our clients on track toward pursuing their long-term objectives. Historically, equity markets have recovered from recessions and downturns. Past performance is no guarantee of future returns. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Third Quarter 2023 Market Returns
Source: Bloomberg
DISCLOSURES
All data sources from Bloomberg as of 9/30/2023.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All indexes mentioned are unmanaged indexes which cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The S&P Midcap 400 Stock Index is an unmanaged index generally representative of the market for the stocks of mid-sized US companies.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The Russell 3000 Growth Index is an unmanaged index comprised of those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index measures the performance of those Russell 3000 companies with lower price-to-book ratios and lower forecasted growth values.
The prices of small cap stocks and mid cap stocks are generally more volatile than large cap stocks. The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following developed country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece,
Hungary, Poland, Qatar, Russia, South Africa. Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand.
The MSCI US Broad Market Index captures broad US equity coverage. The index includes 3,204 constituents across large, mid, small and micro capitalizations, representing about 99% of the US equity universe.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
The Barclays Capital US Corporate High Yield Bond index is an index representative of the universe of fixed-rate, non-investment grade debt.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
The Bloomberg Barclays US Treasury Bills 1-3 Month Index is designed to measure the performance of public obligations of the U.S.
Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months. The Index includes all publicly issued zero coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and at least 1 month, are rated investment grade, and have $300 million or more of outstanding face value.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
Financial planning is a tool intended to review your current financial situation, investment objectives and goals, and suggest potential planning ideas and concepts that may be of benefit. There is no guarantee that financial planning will help you reach your goals.
Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
Diversification does not protect against market risk. All investing involves risk which you should be prepared to bear.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Winthrop Wealth, a Registered Investment Advisor and separate entity from LPL Financial.
< COMMENTARY
Market Commentary | October 04, 2023
Q3’2023 Market Review and Outlook
By Andrew Murphy, CFA
Co-Chief Investment Officer
Q3 2023 Market Highlights: US Equity & Fixed Income Review, Inflation, Fed Policy, and Outlook. Discover key insights into market performance, treasury yields, inflation trends, and the Federal Reserve's stance. Get a comprehensive analysis of the US economy and both short-term and long-term market outlooks
Print/Download Written Commentary
Third Quarter 2023 Highlights
» US Equity Markets: The market declined in the third quarter as the S&P 500 decreased by -3.3%, but after increasing by +16.9% in the first half of 2023, the year-to-date gain is still +13.1%. The market reached its high point for the year on July 31st but declined by -6% through the end of the quarter. The S&P 500 is now higher by about 22% from the bear market low reached on October 12, 2022, when the market fell by -24.5% from peak-to-trough.
» US Fixed Income Market: The Bloomberg US Aggregate Bond index (Agg), which acts as a proxy for the intermediate-term investment-grade bond market, decreased by -3.2% in the third quarter as the 10-Year Treasury yield increased to 4.58% in the period (bond prices move inversely to interest rates and credit spreads). The bond market has now declined by -1.2% in 2023. The yield to maturity on the US Aggregate Bond index was 5.4% at the end of the quarter, which is the highest level since 2008.
» Treasury Yields: Yields increased across the Treasury curve. The 2-Year Treasury increased from 4.88% to 5.05% and the 10-Year rose from 3.84% to 4.58% during the quarter. Interest rates moved higher due to the economy performing better than expected, still-elevated inflation, higher oil prices, a renewed focus on the country’s debt and deficit problem, and the Fed’s new “higher-for-longer” outlook combined with their quantitative tightening program.
» Inflation: Most inflation readings have decelerated from peak levels with several indicators returning to normalized ranges. While the Fed acknowledges overall progress, they are not pleased with the pace of disinflation in the services sector as measured by the Core Personal Consumption Expenditure (PCE) Index. The latest Core PCE Inflation reading of +3.9% is still well above the Fed’s 2.0% target.
» The Fed: The FOMC raised the federal funds rate 25 basis points (0.25%) at their July meeting before pausing rate hikes in September. The top end of the federal funds rate now stands at 5.50%. Since March of 2022, the Fed has increased interest rates by 5.25% total for one of the quickest tightening cycles in United States history. The FOMC’s most recent Summary of Economic Projections (SEP) showed that the median participant expects one more rate hike this year before they cut rates by 50 basis points (0.50%) to 5.1% in 2024.
» US Economy: The resiliency of the economy this year has surprised many observers, including us. Even the Fed is taking a more optimistic view and is no longer forecasting a recession in 2023. The perceived odds of a soft-landing, where the economy avoids a recession while inflation decelerates toward the Fed’s 2% target, have increased. Real GDP growth for 2023 is now estimated at +2.0%, compared with a forecast of +0.3% at the start of the year.
» Short-Term Market Outlook: Over the summer, we wrote that we were turning cautious after the market broke above its 14-month trading range of 3,600 to 4,300 and headed toward 4,600. Given our cautious view at the time, many of our actively managed portfolios shifted defensively in July and August through a decrease in overall equity exposure. Now that our cautious view has been validated and the market has pulled back into its old trading range, we have upgraded our near-term view to balanced. Although, we are expecting more volatility and for the market to remain rangebound a while longer. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
» Long-Term Market Outlook: In our view, investors with a globally diversified portfolio and a long-term horizon should continue to remain optimistic. Markets have historically increased over time despite frequent drawdowns as successful corporations have been able to figure out ways to generate profits through advances in innovation and productivity. To capitalize on the power of compounding, we believe in the benefits of staying Disciplined, Opportunistic, and Diversified, while Mitigating fees, taxes, and expenses. In our opinion, adhering to a structured process and executing on all these components should help keep our clients on track toward pursuing their long-term objectives. Historically, equity markets have recovered from recessions and downturns. Past performance is no guarantee of future returns. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Please see some of our most recent market commentaries:
• Principles for Long-Term Investing
• The Power of Compounding
• What do Sherpas and financial advisors have in common?
• Bond Primer
US EQUITY MARKETS
The market declined in the third quarter as the S&P 500 decreased by -3.3%, but after increasing by +16.9% in the first half of 2023, the year-to-date gain is still +13.1%. The market reached its high point for the year on July 31st but declined by -6% through the end of the quarter. The S&P 500 is now higher by about 22% from the bear market low reached on October 12, 2022, when the market fell by -24.5% from peak-to-trough. Although the market has had solid performance for nearly the last twelve months, the S&P is still -8% below its all-time high on a total-return basis.
We constantly remind our clients to maintain a long-term viewpoint as markets can be incredibly volatile over the short-term. The stock market has historically gone up over time, but returns are not linear. Since 1928, the S&P 500 has generated a total annualized return of +9.5% despite an average peak-to-trough decline of -15% at some point each year. Market performance over the last two years reinforces our belief in a long-term viewpoint. As noted in our S&P 500 Bear Markets chart, historically challenging environments have created strong buying opportunities for long-term investors. Historically, equity markets have recovered from recessions and downturns. Past performance is no guarantee of future returns. Consider your own risk tolerance, financial circumstances, and time horizon.
The market rally since October was driven by evidence of disinflation, the economy, labor market, and corporate earnings holding up better than expected, and the perceived benefit that artificial intelligence (AI) will have on profits and productivity. The weakness in the third quarter was caused by fears over rising interest rates and the Fed’s “higher-for-longer” outlook. Please see our Client Question: Why do Interest Rates Impact Stock Prices?
Size / Style / Sector
The three worst performing sectors of 2022 are still the top performers this year: Consumer Discretionary (26.6%), Technology (34.7%), and Communication Services (40.4%). Note that these three sectors are the home for the Magnificent 7 stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms), which are still responsible for most of the S&P 500’s gain this year despite mixed results in the quarter. The market often undergoes these violent rotations that can make an under-diversified investor feel like a genius one day and a fool the next. Rather than make risky concentrated bets, we prefer to construct diversified portfolios across regions, countries, market caps, factors, styles, sectors, and industries and tilt toward the areas we feel provide the most potential benefit.
US FIXED INCOME MARKETS
Interest Rates
Yields increased across the Treasury curve. The 2-Year Treasury increased from 4.88% to 5.05% and the 10-Year rose from 3.84% to 4.58% during the quarter. Interest rates moved higher due to the economy performing better than expected, still-elevated inflation, higher oil prices, a renewed focus on the country’s debt and deficit problem, and the Fed’s new “higher-for-longer” outlook combined with their quantitative tightening program.
Fixed Income Objective
As part of diversified portfolios, we purchase bonds with various types, issuers, maturities, and credit ratings. Our objective with fixed income is to pursue ballast, stability, and income in portfolios. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Please see our Client Question: Bond Primer where we detail bond mechanics, characteristics, types, risks, and historical returns.
Short-Term Bonds
Short-term bonds have closer maturities and are consequently less interest rate sensitive than intermediate- or long-term fixed income securities. Pursuing stability and income from short-term bonds, including Treasuries, has been a successful strategy as yields remain elevated. Short-term Treasury yields, including, the 3-Month (5.5%), 6-Month (5.5%), and 12-Month (5.4%) are at their highest levels since the early 2000s. Once the Fed starts cutting the federal funds rate, short-term Treasury yields should also decline. We don’t expect +5% short-term yields to be around forever, but we are opportunistically enjoying them while they last. If interested, please speak with your advisor about our Cash Alternatives Strategy, which is an investment strategy designed for individuals or entities to invest excess cash seeking potentially attractive yields in a conservative portfolio of short-term fixed income, including US Treasuries. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Investing involves risk including loss of principal. This strategy and its related holdings are not FDIC-insured.
Intermediate-Term Bonds
The Bloomberg US Aggregate Bond index (Agg), which acts as a proxy for the intermediate-term investment-grade bond market, decreased by -3.2% in the third quarter as the 10-Year Treasury yield increased to 4.58% in the period (bond prices move inversely to interest rates and credit spreads). The bond market has now declined by -1.2% in 2023. The last two-plus years have been frustrating for intermediate-term fixed income investors as bonds have provided negative returns without any ballast. Since September 1, 2021, the Agg bond index has decreased by about -15% as the 10-Year Treasury yield has increased by nearly 330 basis points (3.3%).
Does this mean that it’s time to throw in the towel and abandon intermediate-term bonds as part of a diversified investment portfolio? No, not in our view. All else equal, we expect intermediate-term bonds to provide both ballast and positive returns in the future once yields stabilize. For both new investors and those that have ridden out the last two years, the good news is that the yield to maturity on the US Aggregate Bond index is now 5.4%, the highest level since 2008. Yield to maturity is defined as the estimated annualized rate of return an investor can expect on a bond if purchased today and held to maturity, assuming the issuer makes all their interest and principal payments (i.e., no defaults). In other words, expected future returns from the Agg bond index have not been this attractive in 15 years. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Inflation
The increase in inflation since early-2021 was driven by supply chain bottlenecks, surging energy prices, strong consumer demand caused by a solid labor market, and massive amounts of stimulus. Most inflation readings have decelerated from peak levels with several indicators returning to normalized ranges. While the Fed acknowledges overall progress, they are not pleased with the pace of disinflation in the services sector as measured by the Core Personal Consumption Expenditure (PCE) Index. The latest Core PCE Inflation reading of +3.9% is still well above the Fed’s 2.0% target.
The Fed has divided inflation into three buckets: goods (decelerating as supply chains normalize), housing (decelerating under rising mortgage rates and just starting to show up in the data), and non-housing related core services (still elevated due to the strong labor market and robust wage growth). The Fed theorizes the best way to decrease services inflation is to lower demand by weakening the labor market and aggregate spending.
The Fed’s latest Summary of Economic Projections show the median participant expects Core PCE Inflation to fall to 3.7% in 2023, 2.6% in 2024, and 2.3% in 2025. Note that the Fed still shows inflation above their 2% target by the end of 2025.
Here are several key inflation indicators and a chart tracking the data since the start of 2020:
• The Bureau of Labor Statistics Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The index includes food and energy prices.
o Latest Reading: 3.7% (August). Peak: 9.1% (June 2022).
• The Core Personal Consumption Expenditure (PCE) Index measures the prices paid by consumers for goods and services based on surveys of what businesses are selling. Core means that the index excludes food and energy prices. This is the Fed’s preferred inflation measure, which they target at an average of 2%.
o Latest Reading: 3.9% (August). Peak: 5.4% (February 2022).
• The Core Producer Price Index (PPI) measures the average change in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.
o Latest Reading: 2.2% (August). Peak: 9.7% (March 2022).
• The Bureau of Labor Statistics Average Hourly Earnings tracks total hourly renumeration (in cash or in kind) paid to employees in return for work done (or paid leave). Data is from the Current Employment Statistics (CES) survey.
o Latest Reading: 4.3% (August). Peak: 8.1% (April 2020).
• The University of Michigan Inflation Expectations data is based on a monthly survey designed to gauge consumer expectations. Participants are asked for their view on annual inflation over the next 5 to 10 years.
o Latest Reading: 2.8% (September). Peak: 3.1% (January 2022).
The Fed
The Federal Reserve serves as the central bank of the United States and performs key functions designed to promote the health of the economy and stability of the financial system. The three key entities include the Board of Governors, twelve Federal Reserve Banks, and the Federal Open Market Committee (FOMC). The FOMC sets monetary policy in accordance with its mandate from Congress: to promote maximum employment, stable prices, and moderate long-term interest rates. According to the Fed, “monetary policy directly affects interest rates; it indirectly affects stock prices, wealth, and currency exchange rates. Through these channels, monetary policy influences spending, investment, production, employment, and inflation in the United States.” Please see our Client Question on The Fed which details the key entities, and the impact monetary policy has on the economy, interest rates, and stock prices.
Interest Rates: The FOMC raised the federal funds rate 25 basis points (0.25%) at their July meeting before pausing rate hikes in September. The top end of the federal funds rate now stands at 5.50%. Since March of 2022, the Fed has increased interest rates by 5.25% total for one of the quickest tightening cycles in United States history. The FOMC’s most recent Summary of Economic Projections (SEP) showed that the median participant expects one more rate hike this year before they cut rates by 50 basis points to 5.1% in 2024. The market is currently pricing in about a 50% chance that the Fed will raise rates again this year and agrees with 50 basis points of cuts in 2024.
Balance Sheet – Quantitative Tightening: The Fed is also reducing the size of their nearly $9 trillion balance sheet. The runoff plan is for monthly caps of about $60 billion for Treasuries and $35 billion for agency mortgage-backed securities. The monthly reduction of about $95 billion is larger than the $50 billion per month pace that was used during the 2017-2019 runoff plan. At the current runoff rate, it will take over 4 years for the Fed’s balance sheet to decrease to its pre-pandemic size.
The Fed is getting ready to turn the page from focusing on how high to raise interest rates to concentrating on how long they should keep rates elevated. Recent speeches from committee members as well as the latest SEP indicate the Fed is forecasting that interest rates will remain “higher-for-longer.” Currently, both the Fed and market pricing expect the federal funds rate to be at 5.1% at the end of 2024. We monitor Fed projections and market pricing closely, but we also recognize that these estimates are only a snapshot in time and will change rapidly as economic data evolves.
How long rates stay elevated will ultimately be a function of how quickly inflation growth declines. The Fed won’t be ready to think about cutting interest rates from present levels until Core PCE Inflation, currently at 3.9%, decelerates further. The reading likely needs to approach 3% to give the Fed enough confidence that inflation is on a sustained downward trajectory to the 2.0% target. Once inflation is contained, the Fed will begin to lower interest rates and ease their foot off the monetary policy brake pedal.
US Economy
The resiliency of the economy this year has surprised many observers, including us. Even the Fed is taking a more optimistic view and is no longer forecasting a recession in 2023. The perceived odds of a soft-landing, where the economy avoids a recession while inflation decelerates toward the Fed’s 2% target, have increased. Real GDP growth for 2023 is now estimated at +2.1%, compared with a forecast of +0.3% at the start of the year.
While we have been pleased with how the economy has performed, there are still reasons for caution. Several recessionary indicators are still flashing yellow or red, including the inverted yield curve, leading economic indicators, and the ISM Manufacturing survey. The economy has been supported by a strong labor market and robust spending, although now there is evidence that the consumer may be running low on purchasing power. Furthermore, the lagged effect of tighter monetary policy, rising oil prices, the United Auto Workers strike, and the resumption of student loan payments will all weigh on near-term economic activity.
We’re taking a wait-and-see approach as the post-pandemic economy has thrown a series of head fakes. At times a recession seemed imminent and at other times we watched as the labor market set new records. We continue to believe that the key to economic growth in 2023 and 2024 is for inflation to become contained so the Fed can stop their tightening cycle before higher interest rates eventually lead to cracks in the labor market and/or the broader economy. Please see our latest data on US Recessions and S&P 500 Performance.
Outlook
We continue to separate our outlook into short- (months) and long-term (years) periods.
Short-Term: Our near-term view is now balanced after the S&P 500 experienced a -6% pullback from July 31st through the end of the quarter. Over the summer, we wrote that we were turning cautious after the market broke above its 14-month trading range of 3,600 to 4,300 and headed toward 4,600. We expected some consolidation after the strong year-to-date performance and stated that a move back down into the upper end of the recent trading range was a probable outcome. Given our cautious view at the time, many of our actively managed portfolios shifted defensively in July and August through a decrease in overall equity and less exposure to certain mega cap stocks that have had massive gains this year. Now that our cautious view has been validated and the market has pulled back into its old trading range, we have upgraded our near-term view to balanced. Although, we are expecting more volatility and for the market to remain rangebound a while longer. We would turn more optimistic as inflation dissipates, the Fed stops their tightening campaign, and fundamentals improve. We would turn more cautious or pessimistic if the market were to break toward all-time highs without fundamental support, if inflation reaccelerates, or interest rates keep marching higher. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
• Long-term: In our view, investors with a globally diversified portfolio and a long-term time horizon should continue to remain optimistic. Markets have historically increased over time despite frequent drawdowns as successful corporations have been able to figure out ways to generate profits through advances in innovation and productivity. To capitalize on the power of compounding, we believe in the benefits of staying Disciplined, Opportunistic, and Diversified, while striving to Mitigate fees, taxes, and expenses.
• Disciplined: consistently applying our investment process and philosophy, which are grounded in a long-term approach.
• Opportunistic: rebalancing, repositioning, and tax-loss harvesting to take advantage of market volatility and dislocations.
• Diversified: seeking to ensure that portfolios are properly allocated across and among asset classes to enhance consistency.
• Mitigate: striving to avoid unnecessary disbursements, including fees, taxes, and expenses.
In our opinion, adhering to a structured process and executing on all these components should help keep our clients on track toward pursuing their long-term objectives. Historically, equity markets have recovered from recessions and downturns. Past performance is no guarantee of future returns. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Third Quarter 2023 Market Returns
DISCLOSURES
All data sources from Bloomberg as of 9/30/2023.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All indexes mentioned are unmanaged indexes which cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The S&P Midcap 400 Stock Index is an unmanaged index generally representative of the market for the stocks of mid-sized US companies.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The Russell 3000 Growth Index is an unmanaged index comprised of those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index measures the performance of those Russell 3000 companies with lower price-to-book ratios and lower forecasted growth values.
The prices of small cap stocks and mid cap stocks are generally more volatile than large cap stocks. The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following developed country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece,
Hungary, Poland, Qatar, Russia, South Africa. Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand.
The MSCI US Broad Market Index captures broad US equity coverage. The index includes 3,204 constituents across large, mid, small and micro capitalizations, representing about 99% of the US equity universe.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
The Barclays Capital US Corporate High Yield Bond index is an index representative of the universe of fixed-rate, non-investment grade debt.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
The Bloomberg Barclays US Treasury Bills 1-3 Month Index is designed to measure the performance of public obligations of the U.S.
Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months. The Index includes all publicly issued zero coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and at least 1 month, are rated investment grade, and have $300 million or more of outstanding face value.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
Financial planning is a tool intended to review your current financial situation, investment objectives and goals, and suggest potential planning ideas and concepts that may be of benefit. There is no guarantee that financial planning will help you reach your goals.
Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
Diversification does not protect against market risk. All investing involves risk which you should be prepared to bear.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Winthrop Wealth, a Registered Investment Advisor and separate entity from LPL Financial.