Financial markets had a challenging third quarter driven by the big three: inflation, Treasury yields, and oil. As the Federal Reserve (Fed) indicated, interest rates would stay higher for longer, resulting in the 10-year U.S. Treasury Bond climbing to a 16-year high of 4.62%, and the S&P 500 Index trading 3.3% lower during the three-month period.
The third quarter represented a reset in expectations. The year’s first seven months were pricing in lower interest rates towards the end of 2023 and into 2024. As inflation remains sticky and U.S. consumers continue to have jobs and spend money, the “higher for longer” interest rate outlook quickly pushed the “lower sooner” narrative to the side, causing stocks to trade lower.
Aside from India, major stock markets lost their first-half momentum and declined during the quarter. For the most part, growth companies (those expected to grow faster than peers in the future) were down more than value stocks (those that are cheap or more driven by the broad economy). Company size did not matter either, as both large and small companies declined a similar amount during the three months. Even at the more granular sector level, most sectors finished lower; energy and communication services (due to Meta’s strong quarter) were the only two sectors to finish in the black.
Looking outside the United States, the story was much of the same. Every major region of the world felt the same pressure, resulting in quarterly drawdowns of 1.5% to 5%. Much like how it felt throughout the quarter, this was a relatively orderly decline. We can point to individual countries that fared worse than average (Argentina and Hong Kong), but for the most part, country returns fell within the range of the broader regions.
The Magnificent Seven took a step back from the dominance they displayed in 2023’s first six months. The Magnificent Seven is the term coined to describe the group of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. These seven stocks were responsible for most of the S&P 500 Index’s performance during the first half of 2023. While the chart below is busy, we can see how drastic the outperformance of these stocks was through the first six months of the year based on how far above the gray line, which is the S&P 500 Index, which appears nearly flat at the bottom. Although that “flat” line was up 16%, it is hard to tell when the top performer, Nvidia, climbed nearly 200%.
Switching gears to the third quarter, market leadership broadened, and it was no longer just the Magnificent Seven that mattered. Again, the below chart is busy but look at the S&P 500 Index (gray line) vs. the Magnificent Seven. During the three-month period, one stock (Amazon) ended with about the same return as the index, three outperformed, and three underperformed.
Between these two scenarios, the anomaly was the first half of the year. Currently, there are 503 stocks in the S&P 500 Index. During the first half of the year, only 27% outperformed the index, while stocks outperforming increased to 40% during the third quarter. Both scenarios are below the long-term average of 49% outperforming. Still, there was much more opportunity to beat the index than at the beginning of the year. Although keeping up with the index was difficult during the first six months of the year, we do not adjust portfolios to keep up with anomalies. We will continue to focus on the long term rather than adjust to short-term surprises.
Like what we experienced in 2022, energy stocks were the best performers during the quarter. Driven by oil’s 25% increase during the three-month period, oil ended the quarter around $95 per barrel after experiencing a year-to-date low of $72 per barrel as recently as June. However, this was not a broad-based increase in energy prices. Natural gas, the primary source for heating homes, was up less than 3% during the quarter and is down nearly 30% on the year. The good news is oil’s price increase should not drive inflation higher, like we saw last year, because the rise in energy is contained to oil, not the whole market.
A supply/demand imbalance has primarily led to oil’s price increase. Major oil producers, the Organization of the Petroleum Exporting Countries (OPEC) and the United States struggle to meet global demand. While some of this supply shortage is driven by OPEC cutting production, it is also the lingering COVID rebound on the demand side of the equation. According to the U.S. Energy Information Administration, the third quarter was the bottom of the supply shortage, hopefully leading to a relief in oil prices in the coming quarters.
The good news on inflation is that it has slowed from last year’s 9% high. However, the bad news is that it remains above the Fed’s 2% target. The Consumer Price Index (CPI) is currently at 3.7%, Core CPI, which excludes food and energy costs from the equation, is 4.4%. As we all can relate, just because inflation has been slowing over the past year, this just means prices are increasing at a slower rate than they were a year ago. Inflation is not decreasing, but instead increasing at a slower pace.
JPMorgan provides a helpful chart displaying what various areas of the economy are contributing to overall inflation. As we can see in the chart below, shelter costs are the most significant contributor to inflation. The way CPI calculates shelter is owner’s equivalent rent (OER), in other words, what would rent cost on a house. This data is gathered by surveying homeowners and asking them what monthly rent they would charge on their house. OER can be very slow to adjust to changes in the housing market, which is one reason why shelter’s contribution to CPI adjusted much slower than prices experienced in the house market. This is also a reason why it is going to be a long path to the Fed’s 2% inflation goal.
Source: JPMorgan Guide to the Markets, U.S. 4Q 2023 as of September 30, 2023.
As we all know, the Fed hiked short-term rates from near 0% to above 5% over the past 18 months, including four hikes totaling 1% so far this year. One of the effects of the quick rise in short-term rates is an inverted yield curve, meaning short-term rates are higher than longer-term rates. At one point during the third quarter, the yield curve inverted to the highest magnitude in over 40 years. However, as the quarter progressed, the inversion lessened as longer-term rates rose, driven by the 10-year U.S. Treasury approaching 5%, which we have not seen since 2007.
Currently, one of the main questions investors are asking is, “Why should I own bonds when cash is yield-ing so much?” Right now, cash is an attractive investment. However, as we are allocating portfolios, we need to look at what is going to be attractive in the future, like why we did not buy the Magnificent Seven stocks when they were doing so well. We do not know how long cash, or any bond for that matter, will yield the current rate, so we want to invest in longer durations than cash to “lock in” these yields for as long as possible. For example, a bond that will mature in 1-3 years is paying around the same as cash. Meaning, we can have this yield for the whole duration of the bond, unlike cash, whose yield can change over very short periods.
As we enter the final quarter of 2023, the only certainty is uncertainty. We avoided a government shutdown to begin October, but now the House of Representatives does not have a speaker as we approach the next budget deadline in mid-November. The labor market remains strong, indicating that consumers are not expecting a recession in the near term. The 10-year Treasury yield is approaching 5%, which could give new meaning to “higher for longer.” Although we do not have the proverbial crystal ball to tell us how to position portfolios amid this uncertainty, we rely on our long-term process of not reacting to shorter-term events. We are keeping portfolios diversified around the world, rebalancing portfolios back to target allocations, and focusing on being successful over the long term, not just the next few months.
Author: Joe Clark, CFA | Director of Research | Allegheny Financial Group | October2023
The information included herein was obtained from sources which we believe reliable. This report is being provided for informational purposes only. It does not represent any specific investment and is not intended to be an offer of sale of any kind. Past performance is not a guarantee of future results.
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