2023 Third Quarter Review and Outlook
Dear Clients,
We hope this letter finds you well. Our third quarter review and outlook focuses on the crosscurrents facing investors at this time. Please don’t hesitate to contact us with any questions or concerns that you may have.
Mixed signals
The third quarter proved challenging for investors, as a tug of war emerged between the economy’s surprising resilience and the Federal Reserve’s determined campaign to lower inflation.
With job creation continuing, consumer prices still high, and corporate earnings holding up better than expected, the Fed raised the benchmark Federal Reserve Rate in July for the eleventh consecutive time. At their subsequent September meeting, they paused this program of rate increases for the first time since March 2022, acknowledging that inflation pressures have eased, but also signaling that rates could rise further as soon as their next meeting in November. Investors were left uncertain about what to expect.
The cumulative change in the Fed Funds Rate – from 0.25% in March 2022 to 5.5% now – represents one of the largest percentage increases in Federal Reserve history. There has been fierce debate over how much more tightening will be necessary to tame inflation, and whether the economy will be tipped into recession in the process.
Adding to the general sense of uncertainty, the US Congress remained mired in dysfunction, with House Speaker Kevin McCarthy being forced out just days after engineering a bi-partisan spending deal to avoid a government shutdown.
Inflation has arguably responded well to the Fed’s prescription of higher rates, falling from over 9% last summer to roughly 3%. But it remains above their target inflation rate of 2%. In the meantime, bond yields have climbed to their highest levels since before the financial crisis of 2008, while mortgage rates are at heights not seen in over two decades.[1]
This rise has not been lost on fixed income investors. So far, 2023 marks the third year in a row of negative returns for bond markets, which slumped on concerns about further rate increases, ending the third quarter in negative territory.[2] Stock markets have also taken note, with economically sensitive tech and cyclical stocks falling 7% since late July.
Despite stocks’ Q3 slump, the MSCI All Country World Index returned a still-robust +10.1% for the first nine months of 2023. However, continuing the theme of mixed signals, markets’ apparent strength this year masks a broad backdrop of lackluster returns. Gains this year have come almost entirely from the mega-cap tech stocks now called the “magnificent seven” (Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla), which benefited from a surge of investor interest in artificial intelligence and returned an average 87% through September.
The narrow apportionment of this bonanza is best illustrated in a statistic that evokes a whiff of the dot.com era: the largest ten stocks have driven 97% of the S&P 500’s + 13% return this year and now account for 32% of the index’s value, despite producing only 22% of its earnings. The other 490 stocks have on average posted low single digit returns.
An uncertain economic outlook
The chorus of experts predicting a recession as we headed into 2023 has changed its tune in the face of the economy’s resilience, with most now suggesting a “soft landing” in which growth slows, but not enough to cause a steep decline in earnings or employment.
Whether such a benign outcome materializes remains to be seen. There are a host of concerns about economic resilience: slowing GDP growth, reduced corporate capital spending, and moribund home sales. Consumers are grappling with the depletion of their pandemic savings, the resumption of student loan repayments, and ballooning credit card balances. Loan defaults are increasing. China, the world’s second largest economy, faces severe short-term economic pressures made worse by long-term demographic trends. The war still rages in Ukraine. Though wage gains and a tight labor market may keep the US economy out of recession well into 2024 or later, the rate of growth seems likely to keep slowing, exacerbating the risk of a stall-out.
On the other hand, more tepid growth is likely to help bring down the inflation rate, which could reach the Fed’s 2% target level by late 2024. If so, the Fed would be more willing to begin cutting rates as recession concerns return to the forefront.
Where to find value in this market?
Even after its recent slump, the US stock market is slightly more expensive than normal. However, valuations are distorted by the sky-high prices of large growth companies. Looking further afield, pockets of value can still be found. Smaller cap stocks have been largely excluded from the rally and are trading well below historic multiples. International markets have underperformed the US for a record 15 years and look cheap by comparison.
Most notably, we believe bond markets offer an attractive risk/reward opportunity for patient investors. Investment grade bonds offer high current yields of over 5% and are trading at their lowest valuations in two decades. Interest rates seem unlikely to rise very much more, limiting the risk of losses on bonds we buy at these levels. If rates begin to decline, investors who have locked in yields on longer duration securities will potentially also benefit from capital gains as bonds rally. Despite the allure of investing in risk-free short-term T-bills, money market funds, and bank CDs at yields over 5%, investors who do so risk missing out on this longer-term opportunity.
We seem to be transitioning out of the post-pandemic paradigm that was characterized by shortages of goods and a tsunami of government and central bank stimulus, which in turn sparked the economic recovery, a record decline in unemployment, spiraling inflation, and rising interest rates. It has been a turbulent time and we believe that the aftershocks will continue to reverberate through the economy. Pivot points are identified only in retrospect, but we would venture that 2024 will see global markets moving into a new phase where interest rates stabilize or decline while pricing pressures ease and the economy continues to cool. Such an environment should prove a relief to beleaguered bond markets, while equity investors who focus on overlooked or unloved sectors may also benefit.
LongView Notes
Our sustainability manager and operations coordinator Leah Cantor moved to New York City in August to begin a Master of Science in Sustainability Management at Columbia University. Leah will continue to work remotely for LongView while she pursues her degree. Please see her recent blog on NYC Climate Week on our website.
Our educational webinar series on women and investing with personal finance expert Bridget Jones is also posted on the website under the Resources tab. These webinars offer practical advice to empower people of different walks of life around building a secure financial future. Please feel free to share the website link with friends or family who you think might be interested.
This fall, we celebrate Ernestina and Emily’s first employment anniversaries. They have been tremendous additions to our team, assisting with client services, portfolio management, and financial planning, and we are grateful to work with them.
Finally, for our clients who are required to take required minimum distributions (RMDs) from retirement accounts, or who are considering making year-end qualified charitable distributions (QCDs), please look out for Maria’s email next week explaining the steps you will need to take.
We wish you a beautiful fall and holiday season!
The LongView Team