September 2023
US Economy: Less optimism.
While headline unemployment dipped to 3.5%, most indicators underscored labor market cooling. Among them: a drop in current job openings (to 8.8 million); fewer small businesses planning to hire (17%) and fewer people quitting their jobs (3.5 million in July), bringing each of these indicators to their lowest level since early 2021. Meanwhile, higher borrowing costs erased a summer spike in consumer confidence, the sharpest contraction in two years.
US Stocks: Waiting on the Fed.
U.S. equities fell modestly but stayed in the black for Q3 through August, with more economically sensitive small-cap stocks the weakest performers. Higher interest rates and tighter bank lending standards are now being more keenly felt by consumers and businesses. Consequently, investors are wary of another Fed interest rate hike, which may not happen in Sept., given recent Fed comments and weaker economic data.
Foreign Stocks: Concern about China.
International equities have generally mirrored U.S. equity markets, with many economies facing similar challenges, including inflation. The outlier is China (-9.0%), which is facing capital outflows amid deflation, weaker growth, high levels of business/consumer debt, and structural youth unemployment. Conversely, India and Mexico seem to be early beneficiaries of the near- and friend-shoring trend we have been discussing for some time.
Fixed Income: Short maturities rule.
Since May, interest rates have resumed their climb. The yield on the U.S. 10-Year Treasury note is nearly at the peak hit late last year (4.2%) amid expectations that the Fed will have to keep its target interest rate elevated for longer. With that backdrop, shorter maturity bonds and some higher-yielding corporate bonds outperformed, while arguably overvalued municipal bonds came back to earth somewhat.
Real Assets: Commodities hold up.
As with equity markets, most types of real assets posted weak or negative returns in August. Commodities were the strongest relative performers, despite an environment characterized by global economic weakening: The energy subcomponent was up 2.4% on tighter crude oil supplies. On the fixed-income side of the asset class, Treasury Inflation Protected Securities (TIPS) fell given the rise in interest rates.
Alternatives: Riding the turbulence.
Hedge funds were among the strongest performers as both traditional stocks and bonds finished August in the red. Absolute return-oriented strategies (+0.7%) often perform well in environments with higher volatility, which was the case for the bulk of August. Market directional hedge funds (-0.5%) were an exception, although they remain the best-performing alt strategies so far in 2023, given strong global equity results.
Source of data: Bloomberg
Equities Total Return
| AUG | YTD | 1 YR | |
|---|---|---|---|
| U.S. Large Cap | (1.6%) | 18.7% | 15.9% |
| U.S. Small Cap | (5.0%) | 8.9% | 4.6% |
| U.S. Growth | (1.1%) | 31.0% | 21.0% |
| U.S. Value | (2.8%) | 5.8% | 8.2% |
| Int’l Developed | (3.8%) | 10.9% | 17.9% |
| Emerging Markets | (6.2%) | 4.6% | 1.3% |
Fixed Income Total Return
| AUG | YTD | 1 YR | |
|---|---|---|---|
| Taxable | |||
| U.S. Agg. Bond | (0.6%) | 1.4% | (1.2%) |
| TIPS | (0.9%) | 1.1% | (3.7%) |
| U.S. High Yield | 0.3% | 7.2% | 7.0% |
| Int’l Developed | (0.2%) | 0.9% | (3.5%) |
| Emerging Markets | 0.3% | 4.7% | 5.4% |
| Tax-Exempt | |||
| Intermediate Munis | (0.5%) | 0.9% | 1.1% |
| Munis Broad Mkt | (1.2%) | 1.8% | 2.0% |
Non-Traditional Assets Total Return
| AUG | YTD | 1 YR | |
|---|---|---|---|
| Commodities | (0.8%) | (2.8%) | (8.7%) |
| REITs | (3.3%) | 1.5% | (7.7%) |
| Infrastructure | (4.7%) | 1.0% | (1.1%) |
| Hedge Funds | |||
| Absolute Return | 0.7% | 0.8% | 2.8% |
| Overall HF Market | 0.3% | 1.5% | 0.8% |
| Managed Futures | (0.4%) | (1.5%) | (3.2%) |
Economic Indicators
| AUG-23 | FEB-22 | AUG-22 | |
|---|---|---|---|
| Equity Volatility | 13.6 | 20.7 | 25.9 |
| Implied Inflation | 2.2% | 2.4% | 2.5% |
| Gold Spot $/OZ | $1940.2 | $1826.9 | $1711.0 |
| Oil ($/BBL) | $86.9 | $83.9 | $96.5 |
| U.S. Dollar Index | 121.0 | 121.4 | 123.5 |
Our Take
The game of tug-of-war playing out in the economy and financial markets (contraction vs. expansion), which we have highlighted in recent commentaries, remained in stalemate in August, although an argument could be made that the forces of contraction gained a small amount of ground.
While consumer spending showed a robust increase in July over June (+0.8%), the data as we enter the Fall make for a less rosy scenario, including: Cooling in the labor market and wage growth, which has been steadily falling from the multi-decade peak hit in June 2022, and deterioration in consumer confidence, something that materialized quite quickly.
Meanwhile, the Fed’s preferred inflation gauge (the Core PCE) has risen over the past two months at the slowest pace since 2020. That pace annualized would amount to U.S. inflation of 2.4%, close to the Fed’s target of 2% and a welcome respite from much higher inflation in 2022-early 2023. Still, the price paid for lower core inflation is often a weakening economy.
So far, the U.S. economy has avoided a drop-off in economic activity, as growth in services making up for the sluggish manufacturing sector. Prior to August, the financial markets certainly benefited from consensus sentiment that a severe recession would be avoided. That said, the focus of investors continues to be how much the economy will slow down, given that the cost of credit for consumers and businesses is a key variable in economic growth.
Impact of Higher Rates
When interest rates rise steeply as they have been since March 2022, borrowing money to spend or invest becomes more expensive, curbing economic growth. Look no further than mortgage rates. Two years ago, a $500,000 mortgage at 2.8% would have a monthly payment of $2,054. Today, that same mortgage at 7.5% would cost 70% more, or $3,496 a month.
While the impact on the housing market so far has been muted due to low supply, higher borrowing costs are hitting consumer auto and credit card payments and business lines of credit and other financing. Accelerating erosion in the creditworthiness of credit card holders was a key theme in recent earnings reports coming from many notable retailers.
Also, recent employment data indicate an increase in part-time work, people holding more than one job (double counting). Meanwhile, the average hours worked per week continues to fall. If you adjust for the contraction in the workweek, there has been no job growth at all this year, resulting in an unemployment rate that is closer to 4% than the 3.5% reported.
That we haven’t seen more substantial cooling is likely due to the extended era of low fixed interest rates on mortgages and personal credit, coupled with businesses’ high cash holdings. The impact of Fed policy plays out a bit like steering a boat rather than driving a Toyota Prius: You have to arrest your turn before you are pointed in the direction you want to go. Said another way, Fed policy always comes with a bit of lag.
What does this mean for investment portfolios? Well, it doesn’t mean that we are necessarily in an unfit environment for investment even if the economy does sour a bit from here. Our portfolios are built with client strategic objectives in mind and to withstand the ebbs and flows of the economy and financial markets.
This could be an opportune time, depending on your specific goals, objectives and risk tolerance, to rebalance public equity risk in favor of private equity, private credit, and/or hedge funds, all of which are currently among our strongest conviction allocations for long-term goal attainment. Our investment team is constantly surveying the landscape for timely opportunities, and it is often in the periods of uncertainty or volatility, and in the less travelled corners of financial markets, where we can source the most interesting new strategic positions.
Broadly, corporate credit of various types is an area we are watching closely. Specifically, we are monitoring debt strategies within the commercial real estate market, which is facing an evolution in the usage and demand for real estate alongside the aforementioned rise in financing costs. This includes the peripheral markets around bank lending, including CLOs (Collateralized Loan Obligations) and private debt strategies, which are poised to fill the void created by tighter banking standards. Last but certainly not least, as we have been stating for some time, you are now (finally) getting compensated for owning investment-grade fixed income. Depending on the risk-return profile required to achieve your life goals, a higher allocation to fixed income for yield and stability could make sense.
