After a strong first half in 2023, US equity prices declined in the third quarter as investors continued to focus on the trajectory of interest rates and economic growth. The yields on 10-year US Treasuries climbed from 3.8% at the end of June to 4.6% at the end of September, its highest level since October 2007.¹ In July, the Fed increased their rate by 25 bps for a fourth time this year. While the central bank held rates steady during their last FOMC meeting in September, they have signaled the possibility of another hike before the end of the year. Despite the move higher in rates, the US economy and consumer has shown to be more resilient than anticipated absorbing the higher interest rate regime so far. At the moment, it seems that the Fed has been able to orchestrate the much-hoped-for “soft landing” scenario.
With a strong move upward in rates, the S&P 500 declined in the third quarter by about 3.3% on a total return basis. The drop was broad-based as all but two sectors finished in negative territory for the quarter. Unsurprisingly, rate-sensitive sectors such as Real Estate and Utilities were the two worst performing sectors for the quarter. Additionally, tech-driven sectors which were the big winners in the first half, also lagged in the third quarter, especially in August and September, as the increase in rates weighed on valuations and future growth prospects. Meanwhile, Energy was the lone bright spot of the quarter, gaining over 12%, as oil prices rebounded strongly.
Moving forward, our views have not fundamentally changed. Regarding stocks, we would continue to favor the US. China’s economic recovery has been dramatically slow due to their restrictive COVID policies even though recent macro data seems to indicate some stabilization. Europe’s economy has weathered recent challenges better than expected but may struggle to maintain momentum for the rest of the year due to a sluggish Chinese economy, weakness in global manufacturing and a war that continues to ravage Eastern Europe. Globally, we continue to favor high quality stocks that are able to thrive regardless of the environment. As long-term investors we want to maintain a barbell approach, focusing on growth-driven sectors for long-term capital appreciation, coupled with dividend-paying low volatility stocks that can act as a ballast to the overall portfolio.
Within fixed income, we are focusing on investment grade corporate bonds. From a risk/reward perspective, we do not see added benefits of buying high-yield corporate bonds at this time. The rise in interest rates has also made municipal bonds attractive, especially for high income earners. We believe that on an after-tax basis municipal bonds are providing a healthy risk adjusted return.
One of the big questions in fixed-income is when will the curve begin to normalize. We are starting to see this come to fruition as the curve is flattening with long-term rates beginning to match short-term rates. It will be interesting to see where this normalization will continue to come from. Will it be front end rates moving lower or will long-term rates continue to move higher? We believe that rates will remain “higher for longer” but since it’s impossible to know with any level of certainty, our strategy is to invest in a barbell approach by building a portfolio of short-term (<3 years) maturing bonds coupled with medium-term (5-10 years) maturing bonds. This allows us to lock in higher yields in the medium-term while still having the flexibility to reinvest cash from short-term maturing bonds dependent on interest rates in the future.
Looking forward, a new earnings season will help gauge whether Corporate America remains constructive on growth, even as confidence seems to be waning as some potholes are starting to appear. A looming government shutdown was averted at the last minute but labor strikes, the return of student loan payments and geopolitical tensions in the Middle East have raised concerns recently.
If you would like to discuss our current stance in more details, please contact Greg Painvin, Chief Investment Officer at firstname.lastname@example.org
¹ Bloomberg October 2, 2023 https://www.bloomberg.com/news/articles/2023-10-02/treasury-10-year-yield-reaches-highest-level-since-2007