Third Quarter 2023 Market Update
November 6, 2023
“To suggest that we won’t have a recession in the future simply because we haven’t had one yet, ignores 70 years of economic history and the well known costs of higher rates and inverted curves. This time may be different in some ways, but not THAT different. The timing is always hard to predict with any kind of certainty, especially with all the distortions, but the end result is the same – a recession.” – Global Fixed Income Manager
Third Quarter 2023 Market Update
The third quarter of 2023 was a somewhat difficult period for markets, as most risk assets were negative, partially giving back gains from earlier in the year. Across the board, market participants have continued to digest actions of the U.S. Federal Reserve (the “Fed”), prognosticating about how much higher interest rates may go, and how long they may stay elevated. At its most recent meeting in September, Chair Jerome Powell left rates unchanged (current target Fed Funds rate of 5.25% – 5.50%), however, signaled that they are open to additional rate hikes between now and the end of the year to continue battling inflation, which has started to wane, but continues to be significantly above their long-term target. Despite one of the most aggressive Fed rate hiking cycles in history, having raised the benchmark rate 11 times in 18 months, the U.S. economy and equity markets have been surprisingly resilient to-date, supported mostly by continued strong consumer activity.
Domestic equity markets, as measured by the S&P 500 Index, were negative for the third quarter, returning -3.3%, but remained in positive territory on the year (+13.1% YTD). Energy was the best performing sector during the period, up +12.2% (+6.0% YTD), as the price of oil surged to a 52-week high in September, topping $90+ a barrel, its largest quarterly increase since the invasion of Ukraine. Outside of energy, the only other positive sector during the third quarter was communication services (+3.1%, +40.4% YTD). Interest rate sensitive sectors, including real estate (-9.5%, -8.1% YTD) and utilities (-9.2%, -14.4%), were the worst performing sectors. As discussed last quarter, most of the positive YTD headline returns of the S&P 500 have been driven by very few mega-cap stocks within the consumer discretionary (+26.7% YTD), technology (+34.7% YTD), and communication services (+40.4% YTD) sectors, as markets continue to exhibit very narrow performance. The largest seven companies (Apple, Microsoft, Google, Amazon, Meta, Nvidia, and Tesla) make up approximately 30% of the S&P 500 index today. The divergence in performance is notable when comparing the YTD return of the index using the most quoted market capitalization weighted version (+13.1%), to the YTD return of the equal-weighted version, where all index members are weighted equally irrespective of their market cap (+1.8%), which yields a staggering difference of more than 1,100 basis points.
In other areas of the equity markets, small cap stocks continued to underperform large caps during the quarter, as they are typically more sensitive to economic uncertainty. On a relative basis, small cap stocks have also suffered more than their large cap peers from effective interest rates and associated borrowing costs. Many large cap companies had been able to extend debt maturities in 2021 and 2022, prior to the run up in interest rates, whereas smaller companies are facing some of the highest interest rates in over a decade. As a consequence of this and other factors, small caps have now lagged large caps by their widest margin in over twenty years. Developed international equities, as measured by the MSCI EAFE Index, were down -4.1% for the period (+7.6% YTD) measured in U.S. Dollar (“USD”) terms, amid continued worry about interest rates and slowing growth. Today, stocks outside the U.S. trade at more than a 30% discount to their domestic peers (as measured by forward price-to-earnings or “P/E” ratios), representing a significant discount to their long-term averages (almost two standard deviations below on a relative basis). Emerging market equities were down -2.9% (+2.2% YTD), as measured by the MSCI EAFE Emerging Markets Index (in USD terms) as risk appetite remained muted and ongoing concerns over weakness in the Chinese economy and property sector continued to weigh on markets.
Fixed income markets were also negative, as yields rose sharply during the quarter. Movement of the yield curve included what is referred to as a “bear steepening” when long-term rates increase at a faster rate than short-term rates, a rare occurrence in bond markets, particularly when the yield curve is already inverted. As measured by the Bloomberg U.S. Aggregate Bond Index, bond markets were down -3.2% for the period and remain down on the year (-1.2% YTD), having seen little relief from last year’s sell off. Municipal bonds, U.S. Treasuries, and mortgage-backed securities were all negative over the quarter, whereas investment grade corporate bonds fared slightly better. High yield bonds earned a small positive return over the quarter and are one of the only areas of the fixed income universe with positive returns YTD. The U.S. Treasury yield curve continues to be inverted, a traditional signal that precedes recessions, and the 10-year Treasury yield spiked to nearly 4.6% as of quarter-end.
Storm Clouds on the Horizon
“Fed rate hikes & tighter lending standards have squeezed Main Street, but Wall Street has faced limited pressure—for now.” – Domestic Equity Manager
What some experts have coined “the most anticipated recession ever”, has yet to materialize in the economic data or in capital markets. And while that has seemingly surprised many, there are notable positive dynamics at play within the economic environment that presumably could explain this – a resilient consumer, low unemployment and a labor market that continues to be tight, progress on the Fed’s fight against inflation, strong corporate earnings, etc. – it remains worth noting that the above data points are all backward looking in nature. As we consider the opposite, what lies ahead, we note that there are a growing number of economic indicators, trends, and events that are troubling, could signal turbulence ahead, and are being monitored closely by investors.
In addition to the topics that we have written about in prior notes – an inverted yield curve, the historically lagged effects of interest rate hikes, tighter lending and credit standards, etc. – there are others that we are watching intently, namely around debt service costs and refinancing risks. One area that appears particularly prone to stress and enduring headwinds is the commercial real estate industry, which has been the beneficiary of low interest rates, favorable tax treatment, and a bull market in real assets for many years. Commercial real estate continues to struggle, particularly office buildings in large metropolitan areas, who are seeing elevated vacancy rates due to work from home policies, changes in post-COVID behavior patterns, and other troubling trends making some metropolitan areas less desirable. Since February 2022, the cost of senior real estate financing has roughly doubled, and borrowers (particularly with floating rate debt) are starting to face issues where property cash flows may not be able to cover interest payments. In addition, much ink has been spilled about the looming “maturity wall” in commercial real estate debt, where nearly $1 trillion of debt is set to mature in the next 12-24 months, which must be refinanced at much higher rates.
In addition to the items mentioned above, there are other potentially worrisome data points that have begun to surface around the health of the consumer, such as record high credit card balances, delinquency rates ticking up on credit instruments such as auto loans, etc. As consumers spend down excess savings accumulated during the era of COVID stimulus, a question looms as to how much longer the consumer can continue to spend at current levels.
Interest Rates and the Yield Curve
“We believe that growth and inflation have peaked, and we see greater recession risk than markets are pricing in, which supports a positive outlook for fixed income returns. After their recent rise, starting yield levels, which are historically strongly correlated with returns, are extremely attractive, with both real and nominal yields at levels not seen for a decade or more.” – Global Fixed Income Manager
Yields across the fixed income universe rose sharply over the course of the quarter, with municipal and U.S. Treasury yield curves “bear steepening”. Two-year municipal and Treasury yields rose 73 basis points (0.73%) and 18 basis points (0.18%) over the quarter, as 10-year yields rose 89 basis points (0.89%) and 76 basis points (0.76%), respectively. In fact, the 10-year Treasury, often used as a fundamental valuation benchmark, has risen almost 100 basis points (1.00%) since July, coinciding with volatility and pressure in the equity markets over a similar period. For most market participants, the Fed’s tightening was anticipated to be temporary in nature – a short-term increase to tame inflation, followed by quick cuts and reversion to a more normalized environment – a thesis that has supported equity market strength this year. However, larger than anticipated fiscal deficits that have led to surprisingly high Treasury issuance (and structural concerns around U.S. debt), a resilient consumer-supported economy, and the market’s corresponding acceptance of what could be the reality of a “higher for longer” rate environment, sent Treasury yields towards 16-year highs.
For many investors, fixed income remains a key component of a globally diversified and thoughtfully constructed portfolio. As we continually reevaluate and assess the investment landscape, the outlook for traditional fixed income assets looks much more attractive today than at almost any point over the last decade, given current yield levels. High quality bonds today yield between 5% and 8%, providing investors with attractive current income, and cushion against continued volatility and uncertainty. Fixed income has the potential to appreciate in price when equities and risk assets come under pressure. As a reminder, fixed income prices are inversely related to yields (when yields increase, prices decrease, and vice versa). While the Fed may move forward with further incremental interest rate increases over the course of the next few months, most market participants would agree that we are much closer to the end of the hiking cycle than the beginning, and thus, short- and intermediate-term yields look as compelling as they have over the last decade or two. If a recession or significant slowdown is on the horizon, fixed income should provide an important ballast to portfolios and have the potential to produce meaningful risk-adjusted total returns through yield as well as potential price appreciation.
The investment backdrop for much of 2023 has been positive, as the narrative around an economic soft landing has dominated market sentiment and investors have been given some reprieve from a difficult prior year. Inflation has come down, consumer spending has remained robust, and the economy has outperformed the expectations of most participants. In addition, we are now more than a year past the bottoming of most broad-based equity indices in October of 2022. However, as we head into the last few months of the year, the go-forward outlook remains progressively more uncertain. As concerns continue to grow around the potential for an economic slowdown, there exists several dynamics that merit watching closely. Perhaps the most important is closely monitoring the health of consumers and watching for signs of slowdown, particularly with the resumption of student loan payments (estimated at an average of $200 per month for 20% of the prime component of the work force), dwindling excess pandemic savings, elevated energy prices and rising costs for mortgages and other credit instruments.
While acknowledging the risks and uncertainty that exist today, we continue to believe that a thoughtfully constructed and well diversified portfolio can help investors weather volatility and the inevitable surprises in markets. We continue to remain somewhat cautious and defensive, and as always, strive to manage risk exposures in portfolios to attempt to achieve attractive risk-adjusted returns. Although risks may seem skewed to the downside, we are seeing opportunities today in several asset classes including fixed income, private credit, and certain pockets of the equity markets, that merit consideration within portfolios and we believe have the potential to produce attractive longer-term returns.
As always, we welcome the opportunity to discuss your portfolio in detail and appreciate the trust and confidence that you have placed in Prairie Capital.
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