As we move into the final quarter of 2023, the first half’s market rally has slowed in Q3.
Year to date, the S&P is still up 12% and the tech-heavy NASDAQ is up 28%, but Q3 was the first negative quarter of the year, pulling the S&P down by -3% and the NASDAQ by -4%. Large Cap Growth and Mega Cap names continued to outperform Large Cap Value, however, Energy was the top performing sector in Q3, up 12%, while the Technology sector was down over -5%.
The U.S. economy has continued to power on with broad-based payroll gains throughout Q3 and into Q4. Initial jobless claims remain low, with consumer and business spending continuing to trend higher. The unemployment rate remained at 3.8%, and the labor force participation rate was flat in September at 62.8%. U.S. wage growth was moderate in September, with average hourly earnings up 0.2% per month and slowing to 4.2% per year. Numerous central banks, the U.S. Fed included, are moving from tightening policy to a wait-and-see approach, encouraged by a continuing trend of slowing wage growth and inflation.
Interest Rates
The U.S. Federal Reserve raised rates another 25 basis points in July and paused in September to assess the need for additional increases. It’s a toss-up whether they’ll raise again before the end of the year, but much of the economic tightening the Fed was hoping for is in place. Lending has become restrictive for consumers and businesses, and higher rates continue to push buyers out of the market.
Mortgage rates are closing in on 8%, a number not seen since 2000. Compared to 2021, a $400,000 30-year mortgage would have cost $1,644 per month at 2.8%. Now at 7.9%, that payment is $2,907 — a 77% increase. At the beginning of the year there were projections the Fed would be cutting rates by now, however, they’ve made it clear they’re focused on bringing down inflation and will keep rates higher for longer. In June the Bank for International Settlements wrote that when considering policy adjustments, the “last mile may pose the biggest challenge.” The Fed may find moving from 5% inflation to 3% easier than moving from 3% to 2%. Those final numbers include “sticky” prices that only recessionary environments tend to bring down. Monetary policy will likely remain restrictive as long as price pressures persist.
Consumer Spending and Rolling Recessions
In the face of persistent interest rate increases and inflation, the economy continues to show strength. Job numbers are up, and consumer and business spending remain positive. We see additional headwinds for the consumer: student loan payments are restarting, gas prices are up, lending remains restrictive, turmoil continues in the Middle East, and wage increases have not kept up with inflation. At some point, the restrictive policy will slow the economy. Will we see a sudden downturn, or can the US Economy pull off a “soft landing” where the economy slows gradually without a recession? Theres also the possibility of a rolling recession.
In a rolling recession, different sectors of the economy experience downturns at different times. After a down sector recovers, the slowdown “rolls” to another, but the overall economy remains positive. We’ve seen some examples since the pandemic: the travel and service sectors were hit hard in 2020 during lockdowns but have since rallied back above 2019 levels. Manufacturing turned down in 2020, rallied in 2021 and 2022, and moved back toward average in 2023. Housing contracted last year when the Fed started raising interest rates and existing home sales were down nearly 40%. Now the residential housing market is starting to recover while other areas, such as commercial real estate, are beginning to show weakness. Commercial banks took a hit in March, but the Government stepped in to guarantee accounts and restrict losses.
If these contractions and recoveries continue, we could wind up in an environment where GDP does not turn negative. In Q2, GDP grew at an annual rate of 2.4%, above consensus estimates and Q1’s 2%.
Spending, Saving, and Fixed Income
On the plus side, as spending becomes less appealing, saving becomes more attractive. Interest rates on money market funds, CDs, and short-term bonds have been close to 5% since Q2, but now longer-term rates are starting to move as the yield curve becomes less inverted. Investors can lock in a risk-free yield, as the 10-year treasury rate hit 4.8% in early October. The last time the 10-year was 5% was 2007.
Naturally, during the past 16 years of low yield in the fixed-income space, many investors have migrated away from bonds into equities as a substitute. There was even an acronym, TINA (there is no alternative) to the equity market. However, the equity market comes with a higher level of risk and volatility when compared to fixed income. Now that bond yields are rising, we believe it’s prudent to reevaluate asset allocations. Lower interest rate volatility combined with a higher yield environment presents a compelling opportunity to de-risk accounts where appropriate.
Within our managed portfolios we remain conservative, still favoring Large Cap Value over Growth, Mid, and Small Cap markets. We’ve added to International Developed markets, as valuations remain favorable compared to the U.S. Japan has been one of the best performing countries in International Developed this year. We shifted a small percentage into U.S. Large Cap Core to take advantage of some of the drawdown we’ve seen in Q3 but remain underweight versus the benchmark. We remain underweight in Emerging Markets as China makes up the bulk of the sector and is still struggling to return to post-COVID levels. In fixed income, we continue to favor high-quality, short-term bonds and remain below benchmark duration. We have added duration tactically as the Fed slows rate increases and will continue to move closer to benchmark duration as the yield curve becomes less inverted.
Remember, your investment strategy should be tailored to your long-term objectives. Short-term market fluctuations can be unpredictable, but thorough planning, risk management, proper asset allocation, and diversification are fundamental to sustained financial success. SIMA offers a suite of investment solutions and expert guidance to help you navigate the market. Please contact us to schedule a meeting to discuss your individual financial needs and goals.
Heather A. Voight, AIF® | Portfolio Manager;
Previous market commentaries
2023 Second Quarter Market Commentary
2023 First Quarter Market Commentary
2022 Fourth Quarter Market Commentary
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