|Thayer Commentary – Five Key Questions |
How did the financial markets do in 3Q23, and what drove returns?
Stocks and bonds both retreated in the third quarter, respectively reducing and reversing year-to-date gains. A September stock sell-off more than offset gains from the prior two months, with the ACWI world stock index posting a 2.7% quarterly loss after a 4.3% drop in the final month. Modest bond losses in the first two months became much more significant by quarter-end, as the broad AGG index lost 3.0% in the three months after a 2.5% drop in September. Year-to-date, the ACWI is still up 9.9%, while the AGG is down 1.0%.
As has been the case in so many pivots to autumn over the decades, markets engaged in a reality check. While in past years that check often led to refined and trimmed earnings forecasts for the succeeding year, this year’s focus was largely on Federal Reserve rate policy. Markets have suffered a shift in mindset from 1) the bank’s aggressive rate hike campaign representing a temporary bout of hard medicine to 2) the hikes indicating more a return to normal interest rates, supported by a remarkably resilient economy and forestalled recession. This has pushed Treasury bond rates to 16-year highs and prolonged the worst Treasury bond bear market in history, by far, spanning more than 200 years (about a 25% loss, with no others worse than 20%, and all others followed by quick recoveries).
How has a better-than-expected economy affected financial markets?
Looking more closely, the U.S. Treasury bond’s yield curve has told the economy’s story in recent months. Since March of 2022, we’ve had an inverted curve — meaning short rates higher than long ones, usually measured by the 2-year and 10-year Treasuries, and a traditional recession predictor. The inversion has markedly compressed just since June 30 of this year, from 1.06% (a 4.90% 2-year, and 3.84% 10-year) to just 0.28% (5.08%, 4.80%) as this is written. The move coming almost entirely at the long end reflects greater confidence in the economy’s staying power. It also has created mark to market drops in bond pricing across all main categories.
Economic resiliency has powered growth stocks over defensive ones so far this year. The S&P 500’s 13.1% year-to-date return, after a 4.0% drop in the third quarter, has been very notable in its narrowness. Seven major technology, consumer and communication stocks, now representing roughly 30% of the index — Nvidia, Microsoft, Alphabet, Apple, Tesla, Amazon and Meta – have collectively gained about 68% over the three quarters. The other 493 stocks, or 70% of the S&P, are down around 6%. Key sectors such as financial services, health care, and consumer stapes all have posted negative returns so far in 2023. Predictably, the S&P’s 2023 return is bracketed by respective 27.1% and 2.7% gains by the tech-heavy NASDAQ and the more diversified Dow Jones index.
How resilient is the economy and why?
Economic outlooks, while dull, generally do not call for recession through 2024. The International Monetary Fund, for example, is looking for 1.4% expansion in the U.S. next year (in line with most advanced economies) after two years at 2.1%. Why haven’t we seen recession due to the Fed’s treatment? For one thing, not all policymakers are on the same page: while Fed monetary policy has been on a restrictive path since kicking off a 5.25% total rate hike campaign in March of 2022 (reaching 5.50%, a 22 year high, this past July), the fiscal side, government spending, has been expansionary since COVID and $6.7 trillion of added spending under then-president Donald Trump. Under President Biden, further COVID relief as well as the Inflation Reduction Act and bills supporting infrastructure and semiconductor manufacturing have kept the fiscal posture in “go” mode.
Recession also has been forestalled by a well-employed, reasonably well paid, and still-spending consumer. With consumption accounting for roughly two-thirds of economic output, government spending still robust, and corporate health (and spending) still on solid ground, none of the main GDP components point towards negative economic growth. The September jobs report was well above expectations with prior period upward revisions, accompanied by Goldilocks-level wage gains: a healthy 4.3% on a year-to-year basis, while slowing a bit to a 3.4% annual rate over the last three months, which is compatible with the Fed’s inflation goal at or close to 2%.
Will fiscal policy receive greater attention as the election approaches?
Especially given their high height, federal spending levels are as contentious as ever on Capitol Hill, as we’re now witnessing within the House speakership drama, which followed shutdown gyrations. Now with higher interest rates, debt and deficit size ($33.5 trillion and $1.8 trillion, respectively, according to the real-time national debt clock) will have an even greater impact and become a top issue. Net interest costs are now running around $716 billion, more than doubling 2020’s level, accounting for about 12% of the federal budget and creeping up on our $816 billion in defense outlays. And attendant heavy Treasury issuance, and need to attract buyers, create further upward rate pressure.
Fiscal policy and spending inputs surely will be central issues in the upcoming presidential election. However, neither of the current lead candidates, incumbent president Joe Biden and his predecessor Donald Trump, could lay claim to fiscal rectitude. Both added multiple trillions to the national credit card and both have professed full protection of the massive Social Security and Medicare line items. There are of course important fault lines within each expected platform and debates to come on spending priorities, Ukraine among them. Ukraine funding also is sure to be complicated by the Israel-Hamas war, which involves a closer ally whose support is unquestioned. Also in focus will be tax policy, including whether to extend the 2017 Trump tax cuts, latter up for expiration in 2025, possibly coinciding with the namesake’s return to office.
How attractively valued are stocks and bonds and how are Thayer portfolios generally positioned heading into 2024?
Bonds, following their historic sell-off, are significantly better valued than a couple of years ago. But stocks also look better. Thanks to the receding recession forecast, a firming earnings picture, and a pullback in prices, stocks have begun to look reasonably attractive. After moderate negative quarterly earnings comparisons, a relatively flat third quarter is expected, followed by high single digit growth in the fourth quarter and low double digits in 2024. Having shed almost 7% since the end of July, the S&P 500 now trades at roughly 17.7 times next-twelve-month earnings, compared to a five-year average of 18.6 times. And non-U.S. stocks continue to sell at major discounts, with both developed and emerging markets about 60% cheaper than the U.S. on a price-to-book basis.
Thayer portfolio strategies essentially have completed a move toward more traditional equity and bond exposure, where we see value and also better return visibility. This includes a greater emphasis on low-cost passive exposure, with heavy importance placed on diversification both across and within asset classes. The equity book includes significant coverage of the higher priced but faster growing technology and communications names as well as cheaper higher dividend paying names, along with both developed market and, to a much lesser extent, emerging market commitments. The bond book is designed to both take advantage of higher rates at various maturities and provide defense via a diversified issuer base. As always, the overriding, ongoing goal is the pairing of solid long-term growth and reduced volatility.
David Miller | Miller CPA, LLC & Chris Wilmerding | Thayer Partners, LLC
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