The July-September quarter saw most categories of financial investments post moderate losses. Large-cap U.S. stock prices declined between 2% and 4%, on average, while those of smaller companies fell slightly more. Hindered by a strengthening dollar, overseas equities also struggled, with both developed- and emerging-market categories off between 4% and 5%. Real-estate investments were mixed: broadly diversified holdings were down as much as 9% while timber-related ones gained 2-3%. Commodity prices were higher, on average, though gains were concentrated in the energy sector, with crude oil jumping 27%; copper was flat and gold was off nearly 4%. Bond yields surged, with the benchmark 10-year Treasury finishing at 4.57%, up from 3.82% at the end of June; despite modestly improving credit spreads (the extra yield demanded by investors to compensate for the risk of default), all but very-short-term fixed-income investments posted negative returns.
Among large-capitalization U.S. stocks, those in the Energy, Communication Services, Financial Services and Health Care sectors recorded the best relative performance; Utilities, Consumer Staples, Technology and Industrial names lagged. “Growth-” oriented investments outperformed their “value” counterparts for a third consecutive period, though only narrowly.
Review
A renewed surge in bond yields – which finally eclipsed the October 2022 highs – overwhelmed benign economic and inflation news, leading stocks to their first quarterly loss since last year’s July-September period and extending the three-plus-year bear-market for fixed-income (bond) investments. A surprise jump in the price of crude oil and a renewed rise in the foreign-exchange value of the U.S. dollar added to market turbulence.
The U.S. economy exhibited continued resilience in the face of aggressive Federal Reserve monetary-policy tightening. Aggregate activity (GDP) expanded at a solid +2.1% annual rate in the April-June quarter (compared with +2.2% in the prior quarter). Somewhat anemic underlying consumption (+0.8%) was offset by large gains in non-residential investment (+7.4%) and government spending (+3.4%). More timely data indicated an uptick during the summer, with purchasing-managers surveys improving in both manufacturing and service sectors (the former reaching a 10-month high in September), while consumer spending accelerated. The jobs market remained healthy, with an average of 266 thousand net positions added each month; unemployment nevertheless edged up to 3.8%. House prices continued to recover from their January trough, though monthly gains waned under pressure from the highest mortgage rates since 2000; and after briefly surging in the spring, housing starts resumed their 20-month decline, with the most recent figure the weakest since June 2020. A faltering stock market, high-profile strikes and government dysfunction combined to take a toll on consumer confidence, which receded from a mini-high reached in July.
Overseas economic activity was mostly lackluster. Upward revisions to first-quarter data indicated the Eurozone skirted an early-year recession, while the April-June period featured still-weak (annualized) growth of just +0.5%. Purchasing-managers surveys suggested little improvement in the current period, with the composite measure (combining manufacturing- and service-sector data) reaching a 34-month low in August. The Japanese economy was a bright spot, with second-quarter growth coming in at +4.8% – its best showing in a year. Current-period data suggested some slowing, with September’s composite purchasing-managers survey falling to the lowest level since February. Following a +9.0% first-quarter growth surge after the lifting of pandemic restrictions, the Chinese economy slowed to crawl, expanding at an annualized rate of just +3.2% between April and June. Though an ongoing, slow-motion real-estate crisis continued to sap confidence, late-period data hinted at improvement, with both manufacturing activity and consumer spending tentatively turning higher.
Evidence continued to mount that the Fed was winning its 18-month battle against inflation. Although the headline consumer-price index (CPI) ticked up in both July and August, it most recently stood at just +3.7% (year-over-year), compared with a late-2022 peak of +8.2%. Meanwhile, the more closely watched “core” CPI and the Fed’s preferred core personal-consumption-expenditures (PCE) measure both continued to recede, reaching year-over-year readings of +4.3% and +3.9%, respectively; over the six months through August, the latter advanced at an annualized rate of less than 3%. On the expectations front, market-implied measures, which never rose alarmingly in 2021-2022, remained stable near levels commonly observed in the 2010’s, while the University of Michigan’s consumer survey showed both one- and five-year expectations falling to the lowest levels since early 2021.
Unprepared to declare victory, the U.S. central bank followed a June “pause” with an eleventh rate increase (of 25 basis points, or 0.25%) at its late-July policy-setting meeting, before pausing again in September – leaving the overnight rate-target at 5.25%-5.5%. Communications before and after the September meeting projected a distinctly “hawkish” tone. At the post-meeting press conference, Chair Jerome Powell stated that among the tasks ahead was determining “the extent of additional policy firming,” while the so-called dot-plots (a graphic representation capturing each voting Fed member’s view of future rates, growth, and inflation) suggested one more rate increase later this year (though only 12 of 19 members viewed this as likely). Also projected were stronger economic growth (pegged at +2.1% this year and +1.5% next), very gradually easing inflation (with the Fed’s 2% target not achieved until 2026), and less near-term policy easing (just 50 basis points of rate cuts next year, down from 100 basis points in June; the outlook for an additional 125 basis points of easing in 2025 remained unchanged). (All dot-plot references are the median of 19 individual forecasts; the range of those forecasts can be large. For example, end-2025 interest-rate projections ranged from 2.6% to 5.6%, suggesting a high degree of uncertainty regarding future policy, though also indicating little appetite for additional hikes beyond yearend.)
Within the stock market, July-September results showed few remarkable patterns: nearly all major categories of stocks produced three-month returns in the minus-2% to minus-5% range. The same cannot be said for year-to-date (nine-month) figures, where positive performance was remarkably concentrated among a handful of mega-cap technology/communications/media names: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. From January through September, the median stock in the (large-cap) S&P 500 index was essentially flat (+0.4%); the median small-cap stock was down nearly 7%. The seven tech giants, meanwhile, gained an (unweighted) average of nearly +88%. Likewise, according to calculations performed by research provider Bespoke Investment Group, the 10 largest S&P 500 constituents (the tech giants plus Berkshire Hathaway, Eli Lilly and Visa) provided 88% of the (weighted) index return – the other 490 members contributed just 12%. Other nine-month eye-catchers: NASDAQ 100: +35.2%, Dow Jones Industrials: +2.6%; the (unweighted) average of the three S&P industry-groups that include the tech giants: +31.9%, the average of the other seven groups: -2.3%.
Earnings reported by S&P 500 companies during the quarter (mostly covering the April-June period) tallied 1% below the year-ago figure. Additional small declines expected by Wall Street analysts over the second half would produce a similar (-1%) result for the full year, while recent upgrades have pushed the hoped-for 2024 gain above +11%. Of note: after falling throughout 2022, expected year-ahead earnings have nearly fully recovered through the first nine months of 2023.
What’s Changed?
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the -3.3% S&P 500 total return?
Third Quarter (July-September) 2023 | ||
Dividend Income | +0.3% | -3.3% |
+ Change in Earnings | +3.9% | |
+ Change in Valuation | -7.5% | |
= Total Return | -3.3% | |
Our read: Though valuation improved due to a combination of modestly lower prices and slow-but-steady gains in year-ahead earnings, it remains elevated, particularly in light of higher yields on offer from bonds and cash.
Outlook
In its most recent update, the International Monetary Fund (IMF) summarized the global economic outlook as one characterized by “near-term resilience [and] persistent challenges.” That sounds about right to us – and those mixed prospects make for a complicated investment environment.
Recent moves in bond and stock prices seem to be telling different stories about the future. The renewed rise in yields seems to imply an improving-growth outlook: inflation expectations have barely budged, meaning the entire increase has been in real (i.e., inflation-adjusted) rates, which generally track expected growth. Meanwhile, the yield curve (yield difference between short- and long-dated Treasury issues) has steepened and credit spreads have – until very recently – been steady, suggesting fears of a near-term downturn have eased. (Rising real rates may also reflect growing worries about future government spending/deficits, but since government spending is a component of aggregate demand (i.e., growth), this is not really a separate explanation.)
Stock prices, meanwhile, seem to hint at renewed fears of slowing growth (or worse). From May through July, the market gained steadily in response to a drumbeat of improving economic news, and economically sensitive, “cyclical” shares (e.g., basic materials, industrials) clearly outperformed more “defensive” names (e.g., health care, consumer staples). But over the past two months, even as the economic data generally continued to be robust, the advance faltered and leadership shifted (if somewhat tentatively) from cyclicals to defensives.
How to square this apparent conundrum? Reported economic data is mostly backward-looking, reflecting developments weeks or months old. Stock-price patterns could be reflecting nascent – as yet unreported – weakness. Likewise, bond investors could be “looking past” a minor and/or brief near-term slowdown while anticipating higher growth in the years beyond – due perhaps to the productivity-enhancing powers of generative artificial intelligence and/or the impacts of needed climate- and geopolitical-fragmentation-related investments. In any case, we will be watching carefully for signs of which story is closer to the mark.
While it doesn’t entirely explain the renewed run-up in longer-term bond yields, a key recent development has been investor capitulation regarding the Fed’s position that interest rates will need to be “higher for longer” to complete the job of quelling inflation. Since June, market-implied expectations for short-term rates in late 2024 and late 2025 have jumped a full 150 basis points, as investors abruptly abandoned their prior view that the Fed would ease aggressively next year (i.e., where five 25-basis-point cuts were seen in June, investors are now almost in lockstep with the Fed, envisioning just two or three cuts.)
Though we do not doubt the Fed’s resolve (or sincerity), we’re not entirely on board with this expectational shift. The Fed’s insistence on “higher for longer” seems predicated on a forecast that research provider Capital Economics has deemed “the softest of soft landings:” growth slowing almost imperceptibly in coming quarters and inflation taking the better part of three years to return to target. We see ample scope for growth to flag more worryingly and for inflation to recede more precipitously – either (or both) of which could cause the Fed to change its tune.
On the growth front, numerous headwinds could make the apparent third-quarter spurt a flash in the pan. These include the latest leg-up in interest rates (directly suppressing demand and potentially renewing financial-sector turmoil); tighter bank-lending standards; the autoworkers’ (and other) strikes; a still-possible government shut-down; resumed student-debt payments; delayed tax deadlines in several states including California; and peaking (and then fading) industrial investment tied to federal Inflation-Reduction Act (IRA) and Chips and Science Act (CHIPS) programs. Slowing is likely to be a global phenomenon, too: the IMF recently projected weakening in all major regions apart from Europe over the year ahead, resulting in overall growth of just 3% – which the Fund characterized as “weak by historical standards.”
As for inflation, the more data we see, the more the post-pandemic surge looks to us like the “benign” episodes following each of the twentieth-century world wars (when inflation dissipated relatively painlessly as economies returned to more normal, peace-time ways) and less like the “malign” experience of the 1970s (the aggressive “taming” of which precipitated deep and protracted recessions). As noted above, both hard price data and expectations measures have recently been broadly reassuring. Looking ahead, the lagging nature of rent inputs to official inflation measures, combined with the rapid deceleration seen in more timely data from industry providers like Zillow, should impart significant downward pressure in coming months. Likewise, improving supplier-deliveries performance, normalizing labor-cost increases, and moderating business-hiring plans all suggest continuing disinflation in both goods and services markets.
If either near-term growth disappoints or inflation continues to dissipate rapidly, the Fed’s “higher for longer” stance will become unsustainable. Short-term interest rates 250 basis points or more above (falling) underlying inflation are unquestionably restrictive, while a (decelerating) economy expanding at a rate below 2% is unlikely to overheat. Even if the economic scenario plays out closer to the Fed’s resilient-growth/stubborn-inflation script, the unrelentingly hawkish tone of recent months would seem to skew the odds toward a Fed that turns out to be (at least marginally) more accommodative than expected rather than one that keeps doubling down on restraint.
The above discussion – and the Fed’s own projections – suggest the global monetary-policy regime is approaching an important inflection point. Developing-market central banks have already begun to cut rates, while other developed-country banks will likely follow the Fed’s lead and begin to ease within the next twelve months. The advent of a “global easing cycle” is likely not a time for savvy investors to be overly cautious (remember: “Don’t fight the Fed”).
Nevertheless, we remain concerned about near-term risks. In a flagging-growth, rising-interest-rate environment, projected earnings (that 11% gain Wall Street has penciled in for next year) are at risk. And at 19-times trailing earnings (compared to a more normal 14-16 times) aggregate stock-market valuation remains challenging – especially given rising bond yields. (And, of course, the mega-cap tech/media stocks that have led the market trade at much loftier multiples.) All of this suggests the potential downside remains substantial. However, such a set-up could create attractive opportunities ahead, as potentially heightened market volatility results in more high-quality stocks “on sale” at increasingly attractive valuations. And with the recent boost, money-market, short-term Treasury and high-quality three- to five-year bond yields are now all above 5%, so we’re being paid rather handsomely as we wait for our chance to become more aggressive.
Please contact any member of the Oarsman team if you have questions or suggestions regarding your investments – or if we can be helpful to you in any way.