By Daniel McGarvey, Portfolio Analyst
After a strong first half of the year, the third quarter of 2023 was quite shaky for both stocks and bonds. The S&P 500 returned -3.3%, while the Bloomberg Aggregate Bond Index fell -3.2%. A major contributor to losses was the 10 Year Treasury Rate’s rapid ascent to 4.6%, along with the inflationary concerns brought on by crude oil reaching $91/barrel.
In its September meeting, the Federal Reserve decided to keep interest rates steady with the potential for more hikes if necessary. The Federal Funds Rate is now in the 5.25-5.5% range, 225 basis points higher than one year ago, and futures markets are expecting that this is likely the highest we’ll get in this cycle. They are also indicating higher rates for years to come, meaning that continued tight conditions could bring more pain before we see much economic growth. Of course, these expectations could change quickly as new economic data comes in. Resilient inflation could require more hikes, but a recession could require cuts, and Fed Chair Jerome Powell recently stated that his base case is not a soft landing.
No one knows whether we will actually enter this long-expected recession in the next few quarters, but some cracks are forming, and we lean toward expecting a slowdown before long. It appears that the average consumer is beginning to run low on the savings they built up during the stimulus era, and they could continue to be troubled by mortgage rates at over 20-year highs, increasing gasoline prices and the return of large student loan payments. The expenditures of COVID consumer aid programs were also down $48 billion in Q3, which at an annualized rate would be the equivalent of a $192 billion annual tax increase for consumers. The consumer makes up a large portion of GDP and is now facing significant headwinds. Additionally, most economic leading indicators point in the direction of some pain to come.
A commonly heard rebuttal to the possibility of a recession is that the labor market is still strong. While this is true, typically when the Fed stops raising rates, the unemployment rate has yet to surge. As shown in the chart below, the federal funds rate tends to peak before unemployment rises beyond its 12-month moving average. Additionally, job openings are now falling below their long-term trend, showing more labor weakening than the current unemployment rate might suggest.
Even if a recession does not come in the next few quarters, it will be difficult to escape the eventual repercussions of our government running with such poor fiscal discipline. As part of our massive twin deficit, we have a budget deficit over 5% of GDP, with 65% of that budget indexed to inflation. While higher rates will continue to pressure the debt servicing cost of the Treasury, continued monetary tightness might be needed to not let the inflation-indexed parts of the balance sheet get out of control. We have benefitted from the U.S. dollar’s reserve status recently, but that status can be abused. It would be unwise to assume we’ll keep that reserve status forever, no matter what policy mistakes we make, and there has already been some weakening in the foreign demand for U.S. debt.
Although we were able to avoid a government shutdown in late September, the continued struggle to get deals made could hurt the perception of the U.S. debt and the dollar. We could also run into this situation again in mid-November, and investors are becoming increasingly aware of how difficult it could be to manage our debt load responsibly at this level of political dysfunction.
As alluded to earlier, an increasing source of pain for consumers has been the jump in oil prices as global supply has tightened. In the third quarter, West Texas Intermediate (WTI) crude soared nearly 30%, and it appears that more trouble could be in store with falling inventories domestically and abroad. In prior decades, the U.S. might have responded to price increases with increasing supply, but that seems like less of a sure thing in this environment. Needless to say, continued higher prices are inflationary, and we expect that any meaningful transition to alternative energy sources could still be decades away.
Another source of pain for consumers is housing affordability, a double whammy for spending when combined with higher gas prices (see chart below). With interest rates increasing, home sales have started to weaken again. However, home prices have stabilized as both supply and demand have fallen, likely due to existing homeowners feeling locked in by their current lower mortgage rate. The housing market doesn’t exactly look healthy, but it is not collapsing.
On the international front, we keep getting the sense that, for better or for worse, the world is trending toward deglobalization. With trade tensions high and the ongoing threats of war, many countries are aiming for less foreign reliance and increasing their defense budgets. In the case of the U.S., this trend could be positive for labor but bad for prices, given that deglobalization tends to be inflationary.
Over the third quarter, we saw a retracement of the high-growth names that dominated in the first half of the year. We have not significantly changed our equity allocations, however, as we continue to tilt toward value stocks. We especially prefer high-quality dividend growers, which have a history of outperforming during and after rate hike cycles. Additionally, we are still wary about the top-heaviness of the market, even though its concentration issues have improved slightly in the last few months.
The third quarter was difficult for international stocks as well, and our view remains that we like their valuations but are cautious near term given heightened global tensions.
On the fixed income side, we remain underweight duration due to the attractive yield and safety of the short end, along with our view that long rates could have more room to rise. That being said, we have been gradually extending duration recently as long rates have risen, and the yield curve has begun to normalize. We also continue to prefer high-quality bonds until we see credit spreads widen.
As we have been all year, we are also in favor of holding alternative asset classes that can offer diversification and uncorrelated sources of return in times of uncertainty.
*Charts provided by Strategas Research Partners, LLC and Stansberry & Associates Investment Research, LLC
Material discussed is meant for general/informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. The opinions and forecasts expressed are those of the author and may not actually come to pass. This information is subject to change at any time, based on market and other conditions.
Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.