3rd Quarter 2023 Commentary


Market Performance Overview

  • Domestic equities were negative in Q3 with large cap stocks finishing -3.27% (+13.07% YTD).
  • Foreign equities were negative in Q3 returning -4.11% in developed markets and -2.93% in emerging markets.  YTD, developed markets are up +7.08% and emerging markets are up +1.82%.
  • Domestic bonds were negative in Q3 returning -3.23% for the quarter (-1.21% YTD).
  • Foreign bonds were negative in Q3 finishing the quarter at -0.78% (+2.80% YTD).


Economic Update

Resiliency seems to be the most apt description of the U.S. economy this year.  In fact, the Atlanta Fed GDP model is now calling for an acceleration in growth during the third quarter.  At the same time, inflation is continuing to moderate, helping to spark enthusiasm for a soft landing. However, with tailwinds from the consumer and business sectors likely to fade in the coming months, the path to a soft landing may be narrower than expected.  Meanwhile, reaccelerating growth in a still-tight labor market has complicated things at the Federal Reserve, as they continue to balance the risks of over versus under-tightening.  At its September meeting, the Fed kept rates unchanged at 5.25%-5.50%, but forward guidance left the door open for another hike.  Nevertheless, the Fed does seem to be near the end of tightening and the pace of interest rate cuts next year will be largely dependent on whether or not the U.S. economy falls into a recession.  Current valuations, while still below 2021 levels, do look more expensive compared to historical averages, making the market more sensitive to economic headwinds.

Consumers have remained resilient in the third quarter, supported by solid job growth, and rising real wages.  The pace of job gains, while still robust, has been trending lower since last year. Cooling demand for labor suggests that job growth should decelerate in the coming months.  Additionally, consumers have been depleting their savings balances and taking on more debt to maintain current spending, and delinquencies are starting to rise.  The chart on the right outlines the boom in consumer cash from the COVID stimulus, with roughly 90% of the excess cash being spent already.  This, along with the lagged impacts of monetary tightening, higher energy prices, and the forthcoming resumption of student loan payments, should weigh on consumer spending in the coming months.


Equity Recap

In the wake of last year’s broad market sell-off, lower valuations presented investors with a new slate of opportunities across asset classes. Markets have since seen gains in 2023, but this rebound has not been evenly distributed. While valuations still look better than compared to the end of 2021, some asset classes look more attractive than others.  We have seen gains across all major sub-asset classes in equities, with the S&P 500 being the clear leader thus far in 2023 up +13.07%, followed by International Developed markets at +7.08%.

A surge among some of the largest tech stocks has driven strong gains in the S&P500 so far this year. While this year’s performance is a welcome rebound from last year’s dismal returns, with the S&P500 now trading above 18 times forward earnings, valuations look stretched and warrant some caution.  While investing passively will likely lead to an overweight to expensive parts of the market, active management allows investors to lean into the undervalued segments of the market.

At the end of last year, the global economy was losing steam with only 27% of countries registering a manufacturing PMI above 50, the level associated with accelerating economic momentum. Since then, Europe avoided an energy-induced recession and China lifted its “zero-COVID” policy, raising the prospects for stronger global growth momentum. However, both the Eurozone and China have been weaker than expected, leading to a more challenging global picture.  In China, subdued consumer confidence and business investment have led to a lackluster re-opening, with the government recently enacting accommodative policies to stimulate economic activity. These challenges have spilled over to Europe, where the growth outlook is weakening against a backdrop of still-elevated inflation and manufacturer pessimism. However, there are still some bright spots. In India, cyclical and structural tailwinds have supported the economy and inspired investor enthusiasm. Japan has also benefited from cyclical tailwinds, with increased tourism and exports. Moreover, corporate governance reforms and hotter wage growth are helping to create a more compelling investment story.

With sluggish growth in Europe and China offsetting stronger growth from India and Japan, global activity may be challenged in the coming months. However, lower export prices from China could help the global fight against inflation and a resumption in the dollar’s decline should boost returns for U.S.-based investors. Moreover, emerging markets have performed better outside of China, and investors may find better entry points to key secular themes in technology in East-Asian markets than in the U.S.

As investors assess positioning for the rest of the year and 2024, it’s important to assess both risks and opportunities after this year’s market rally. Within equities, investors may want to lean into international markets and focus on finding attractively valued companies poised to drive long-run returns, diverting some focus away from the top few stocks that have driven this year’s gains.


Fixed Income Recap

Domestic fixed income was negative this quarter, as the Fed increased interest rates yet again. The Fed has continued its strong stance on bringing inflation down to its 2% target.  Fed Chair Jerome Powell has not wavered in his emphasis on the 2% target being their number one priority and he indicated he is willing to keep rates higher for longer if he feels necessary.  This has continued to produce volatility, as the bond market attempts to pinpoint the peak of interest rate hikes. At their September meeting, the Fed left the federal funds rate unchanged in a range of 5.25% – 5.50%. While this move was widely telegraphed, forward guidance indicates there may be another rate hike coming.  Indeed, the median Federal Open Market Committee member still expects one more rate hike this year, but now expects only two cuts in 2024.

It appears the Fed is near, if not already at, the end of its hiking cycle, which will divert investor attention to the potential for rate cuts as opposed to rate hikes. If the economy avoids a recession, the Fed will be able to deliver mild cuts next year. However, if the U.S. economy enters a recession, the Fed may be forced to cut rates rapidly. Both outcomes, however, should bode well for high-quality fixed-income investments.

It is important to note that the bond market is priced very attractively as compared to its 25-year history. It was not long ago that the U.S. bond market was producing a 1.5% annual yield.  The current opportunity presented in fixed income could pass rather quickly once the Fed begins lowering rates, and investors would be well served to take advantage of current yields.


2023 Outlook & Beyond

Strong market performance, moderating inflation, and tight labor markets have allowed consumer sentiment to rebound after its trough in June of 2022. This summer saw a less gloomy consumer, with strong sentiment gains in June and July. However, the fall is splashing some cold water on this exuberance, with higher gasoline prices and the gradual pass-through of higher interest rates to borrowing costs likely weighing on sentiment going forward.

When investors feel gloomy and worried about the outlook, their natural tendency is to sell risky assets. However, history suggests that trying to time markets in this way is a mistake. This illustration shows consumer sentiment over the past 50 years, with 9 distinct peaks and troughs, and how much the S&P 500 gained or lost in the 12 months following. On average, buying at a confidence peak returned 3.5% while buying at a low consumer confidence point returned 24.0%.

Importantly, this is not to suggest that U.S. stocks will return anything like 24.0% in the year ahead, as many other factors will determine that outcome. However, it does suggest that when planning for 2024 and beyond, investors should focus on fundamentals and valuations rather than how they feel about the world.

If you are a client of our firm, we created your portfolio to withstand times such as these.  If you are not a client and have not stress-tested and designed a plan to navigate through uncertain times, perhaps now is the time to do so.  We stand ready and available to assist you.

Charts, graphs, market performance data, and commentary sourced from J.P. Morgan Asset Management.

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