November 2023
US Economy: Treat or trick?
The U.S. economy grew a stellar 4.9% (initial estimate) in the 3rd quarter, generally beating economist expectations. Driving U.S. growth was a spike in consumer spending, increases in government spending and a buildup in business inventories. Doubts about robust growth continuing center on high U.S. interest rates, the drop in inflation-adjusted wages, and a dramatic decline in the savings rate.
US Stocks: Market jitters.
U.S. stock markets lost ground for the 3rd straight month. Investor optimism in the first half of Oct. dissipated as interest rates generally resumed climbing and the ramifications of high interest rates on both personal and business credit markets weighed on sentiment. The energy (-6.2%) and consumer discretionary (-5.2%) sectors were the weakest performers amid fears of an economic slowdown. The so-called “Magnificent 7” stocks (-3.0%) held up a bit better.
Foreign Stocks: Also down.
International stocks did not fare much differently than their domestic counterparts. Nearly every sector of foreign developed equity markets fell. Likewise, no country was particularly accretive to returns. Japan (-3.7%) and the UK (-3.9%) pulled down results the most, on rising rates and monetary policy uncertainty in Japan and deteriorating labor market and business activity data in the UK.
Fixed Income: Higher yields hurt.
Interest rates moved swiftly higher, with the U.S. 10-year Treasury yield touching 5% before settling at 4.9% by the end of Oct. Less-interest-rate-sensitive corners of fixed income were the strong relative performers, with municipals (-0.3%) and high yield bonds (-1.4%) “leaders.” Meanwhile, corporate stress is showing up in the high-yield bond market with the yield spread to Treasuries up 0.7% since mid-Sept.
Real Assets: A glimmer from gold.
Gold (+7.2%) was the only real positive for real assets in Oct., as the Israel-Hamas war created yet another geopolitical hotspot. With that backdrop, investors have sought gold as a “safe haven” along with other precious metals. Similarly, other more defensive corners of real assets such as infrastructure equities (excluding oil & gas pipelines) provided some ballast to portfolios with modestly negative returns.
Alternatives: Hidden opportunities.
The private markets have not been immune to the repricing of risk due to higher interest rates although hedge funds have incrementally outperformed. The higher cost and scarcity of financing will likely hamper some private equity investments faced with declining profitability. That said, with bank lending constrained, non-bank lenders may be able to lock-in advantageous terms for high-yielding loans from real estate to seasoned private equity.
Source of data: Bloomberg
Equities Total Return
| OCT | YTD | 1 YR | |
|---|---|---|---|
| U.S. Large Cap | (2.1%) | 10.7% | 10.1% |
| U.S. Small Cap | (6.8%) | (4.5%) | (8.6%) |
| U.S. Growth | (1.7%) | 21.6% | 17.3% |
| U.S. Value | (3.7%) | (2.1%) | (0.5%) |
| Int’l Developed | (4.1%) | 2.7% | 14.4% |
| Emerging Markets | (3.9%) | (2.1%) | 10.8% |
Fixed Income Total Return
| OCT | YTD | 1 YR | |
|---|---|---|---|
| Taxable | |||
| U.S. Agg. Bond | (1.6%) | (2.8%) | 0.4% |
| TIPS | (0.7%) | (1.5%) | (0.7%) |
| U.S. High Yield | (1.2%) | 4.7% | 5.8% |
| Int’l Developed | (0.6%) | (1.4%) | (3.1%) |
| Emerging Markets | (0.2%) | 3.7% | 5.5% |
| Tax-Exempt | |||
| Intermediate Munis | (0.3%) | (1.2%) | 2.0% |
| Munis Broad Mkt | (1.3%) | (2.3%) | 2.6% |
Non-Traditional Assets Total Return
| OCT | YTD | 1 YR | |
|---|---|---|---|
| Commodities | 0.3% | (3.2%) | (3.0%) |
| REITs | (3.1%) | (8.6%) | (7.9%) |
| Infrastructure | (3.0%) | (6.6%) | (1.3%) |
| Hedge Funds | |||
| Absolute Return | (0.3%) | 1.2% | 0.9% |
| Overall HF Market | (0.8%) | 0.5% | 0.5% |
| Managed Futures | (1.2%) | 0.6% | (4.6%) |
Economic Indicators
| OCT-23 | APR-23 | OCT-22 | |
|---|---|---|---|
| Equity Volatility | 18.1 | 15.8 | 25.9 |
| Implied Inflation | 2.4% | 2.2% | 2.5% |
| Gold Spot $/OZ | $1984 | $1990 | $1634 |
| Oil ($/BBL) | $87 | $80 | $95 |
| U.S. Dollar Index | 124.0 | 119.4 | 127.6 |
Our Take
Summer seemed to end abruptly this year, both literally and figuratively, with frosty mornings and frostier financial markets. In the last few months, sentiment about incoming economic data and Fed policy has shifted much more pessimistically and the geopolitical backdrop has only grown more fractured with the unfortunate developments in the Middle East.
What has changed? From a fundamental standpoint, we do not have new data that suggests a dramatically weaker U.S. economy since the summer started. We have a mixed picture presenting both weakness and strength. On the latter front, 4.9% GDP growth in the 3rd quarter and the low unemployment rate highlight the resiliency of the U.S. economy, something we have pointed to over the last year. Unfortunately, most investors do not realize that relatively strong economic data has preceded many recessions. The prior quarter’s GDP has 0% correlation with growth one or two quarters out. In the past, we have seen growth of 4% or higher during the very quarter that the official recession (per the National Bureau of Economic Research) began.
That the coincident and lagging U.S. economic data have not deteriorated all that much is actually part of the problem. Based on the selloff we have seen in equities and bonds, investors seem to be realizing that Fed policy will likely stay restrictive for longer, and the most obvious consequence of that is that interest rates will remain elevated. In the last few months, longer-term interest rates have risen a bit more quickly than short-term rates, while the derivatives markets are projecting that the Fed funds rate will be higher at the end of 2024 by 70 basis points. The longer that interest rates are elevated, the more difficult it will be for financial markets to avoid disruption as corporate profitability continues to fall and defaults mount.
That stock market performance has hit a rough patch is not particularly surprising, and it could be a self-fulfilling prophecy. Why wouldn’t a savvy investor reduce equity holdings in this type of environment?
We are never keen on projecting near-term results in equity markets, partly because market sentiment tends to be fickle. To wit, in early November sentiment got a boost after the Fed left its target rate unchanged and telegraphed that more time was needed for the impact of previous Fed rate hikes to flow through the economy. Both stocks and bonds reacted positively but not enough to offset losses so far this autumn.
The Case for Bonds
We continue to position portfolios for a more volatile and evolving market regime, created by shifts in the economy to reflect a more multi-polar and fractured world. In doing so, we are focused on two key things: (1) Making sure that the portfolios we have built to attain clients’ long-term objectives are still correctly positioned for those objectives within the context of a more volatile environment; and (2) Continuing to check cognitive and emotional biases that can lead to poor decision-making. Our perspective on one asset class – fixed income — touches on both of these aspects.
Allocating to asset classes that are challenged is often a way to add value. With interest rates and core fixed-income yields rising, the longer-term risk reward tradeoff is now much more positive for bonds and credit-oriented investments than it has been in many years. After years of underperformance, we think fixed income is now well-positioned for better risk-adjusted returns, so we are likely to continue adding to this asset class going forward. Similarly, while deterioration in corporate credit is starting to manifest more clearly, the opportunity set continues to increase in that space. Finally, the heightened risk associated with the potential expansion of the Middle East conflict beyond Gaza-Israel, supports the case for core fixed income and diversifiers.
