Quarterly Market Commentary Third Quarter 2023

Summary

Economic data continues to be mixed as the labor market remains strong, weak manufacturing data seems better than many feared, services data is slowing but still resilient, and inflation remains elevated but improving. Both fixed income and equity markets are coming to grips with the idea that economic data is pointing to an environment where interest rates remain higher for a longer period of time. While the Federal Reserve may be on the tail end of this hiking cycle, a new rate reduction cycle may be further off on the horizon. In addition to a rate hike at the earlier of two Fed meetings this past quarter, energy prices and longer-term interest rates rose, putting more pressure on consumers and businesses alike. While earnings estimates for this quarter are lower than last year, the drop in earnings has slowed. Market sentiment in the quarter reflected these contradictions and a moderate reduction in risk positioning.

Market Summary

The Economy

As we neared the end of the quarter, reports indicated a marked decline in economic data. In particular, the Chicago Fed’s National Activity Index, which tracks 85 different economic indicators, dropped unexpectedly into negative territory, with 50 of the 85 indicators making negative contributions. This followed a slew of economic indicators that showed inflation was still an issue, including increases in key price measurements. The Headline Consumer Price Index (CPI) rose 3.7% over the last 12 months ending in August and Core CPI (ex-Food and Energy) rose 4.3%. The Personal Consumptions Expenditures (PCE) Index (the Fed’s preferred inflation indicator), rose 3.5% over the last 12 months ending in August. The Producer Price Index (PPI) rose 1.6% over the last 12 months ending in August. While the manufacturing side of the economy remains in contraction, services remain in expansion, according to the Institute for Supply Management (ISM) Purchasing Managers’ Index (PMI). Some of the data in early September was enough to make September’s Fed meeting top of mind, where the Fed left rates unchanged, following their last 25 basis point (bps) hike in July. They did project one more 25 bps hike before the end of the year while setting expectations that they were nearing the end of this hiking cycle.

The Real Estate market showed slowing momentum as new home sales fell in August but remain higher than this time last year. Rising prices and mortgage rates have impacted home sales, causing both existing home sales and new home sales to drop during the quarter. Prices are rising despite a fall in activity because there are so few sellers. Rents, which make up 17% of the PCE Index, also continued upward, showing that inflation is still lingering. In addition, WTI Crude Oil rose more than 25% to the $90 level.

Consumers have continued to spend on the strength of a healthy labor market, where unemployment remains under 4% and available new jobs still exceed pre-pandemic levels, despite moderating from twelve million last year to eight million in July. Having used up a substantial amount of their pandemic savings, consumers appear to be supporting their activity by building credit balances and holding them longer. Credit card balances rose to an all-time high of over one trillion dollars. Delinquency rates for credit card loans and auto loans edged up. Consumer Confidence fell for the second month in a row in September.

Globally, while the European Central Bank raised rates 25 basis points as recently as September 14, other central banks appear to be trying to balance the needs of combating inflation and reigniting growth. The Bank of England paused rate hikes in September, following fourteen consecutive hikes. Japan’s central bank continues to maintain a neutral stance on their rate levels. China’s central bank modestly reduced lending rates for the second time this year.

Markets

Equities and Fixed Income assets both sold off this quarter. The value/growth effect was neutral during the quarter, but growth continues to carry the market year-to-date, with the Russell 1000 Growth returning nearly 25% so far this year and the Russell 1000 Value squeezing out just under 2%.Interest rate sensitive sectors, such as the Utilities, Real Estate and Consumer Staples sectors, led the slide as interest rates rose. The Energy sector was the strongest sector by a large margin, returning more than 11% during the quarter on the strength of a 25% increase in oil prices. For the quarter, the estimated year-over-year earnings decline of the S&P 500 was -0.2%. If this estimate holds, it will mark the fourth straight quarter of earnings declines. However, this estimate would be the lowest decline over that period. The forward 12-month price/earnings ratio for the S&P 500 declined to 18, below the five-year average (18.7) but above the ten-year average (17.5). Smaller companies also underperformed the broader market, as their valuations are more sensitive to price and interest rate changes.

Globally, Emerging Markets slightly outperformed Developed Markets for the quarter but trailed significantly for the year. The Eurozone, in particular, is struggling with continued high inflation, rising interest rates, and Germany, their biggest economy, forecast to slip into recession.

Fixed Income assets sold off as interest rates rose. The 10 year US Treasury rose 76 basis points, to its highest level since 2007, before the Great Financial Crisis. The 2- to 10-year US Treasury yield spread inversion eased significantly, reducing the negative spread by more than 50%.

Looking Forward

The fourth quarter of 2023 will have some additional risks beyond the issues of inflation and growth. Government budget battles, labor stoppages, and the resumption of student loan payments could add to economic uncertainty. Higher wages and interest rates, coupled with cautious expectations for consumer spending for the rest of the year, could mute holiday hiring, affecting delivery times and volumes. This is on top of high oil prices, historically high government debt and restrictive interest rates, which present longer term risks.

Outside of these risks, the economy appears to be resilient enough that market participants expect U.S. Gross Domestic Product (GDP) to finish the year at more than 2%. A better balance between growth and inflation could be achieved with further supply chain recovery, a slowdown in rent and services inflation, continued disposable income growth, and a sub-4% unemployment rate, easing the pressure to keep interest rates at or above their current level.

While markets appear to price one more Fed rate hike, both Main St. and Wall St. would laud an end to monetary tightening. A stable interest rate environment would allow consumers and businesses to plan better and make financial decisions. Looking into the new year, the unemployment rate will likely rise modestly, especially as the number of available workers rises in response to higher wages, a further reduction in pandemic savings and a return to pre-pandemic immigration levels.

While market valuations remain rich, an end to rate hikes and the absence of a deep, painful recession would be positive for risk assets. Softening inflation, a resilient consumer and reduced pressure on interest rates would allow corporations to maintain and potentially grow margins, volumes and earnings. There are several stiff headwinds on the near-term horizon that put that rosy picture at risk but the long-term view has better potential.

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