Q3 2023 US Market Review & Outlook
Rising interest rates weighed on stocks and bonds this quarter. The Federal Reserve (Fed) increased short-term interest rates by 0.25% at their July meeting and left rates unchanged in their September meeting. The September meeting went as expected, although the Fed signaled its commitment to keeping short-term interest rates higher for longer. The Fed has been saying this for a while, but the market is finally realizing the Fed is planning to keep its word. The 10-year bond saw interest rates move from 3.81% on July 1st to 4.6% at quarter end in reaction to the higher for longer sentiment. This is the highest rate in the 10-year treasury since 2007. Robust consumer spending and historically low unemployment have supported solid economic growth, but higher interest rates are starting to cool economic growth.
Stocks saw their first negative quarter in 2023. The artificial intelligence (AI) stock surge which has driven much of this year's gains took a breather over the last few months. The only gains seen this quarter were found in the energy sector. Crude prices jumped 35% since August 1st, propelling the energy sector by 12.2% in the quarter. All other sectors were flat or gave up ground during the past three months.
Investment Strategy
There were no changes to your investment strategy during this quarter. Your portfolio continues to be fully invested in your strategic allocation. We are slightly overweight in US Small-Cap companies and are underweight in US Large-Cap stocks. This continues to be a short-term tactical move because small caps historically have outperformed their bigger peers in new bull markets.
We recommend making the most of short-term rates, but it's important not to become overly infatuated with them. Currently, savings accounts offer returns of over 4%, and money market funds are yielding above 5%. These are excellent options for saving reserves, but shouldn't be seen as a substitute for your long-term investment plan. As time passes, short-term rates are likely to decrease, while your strategic allocation will have higher returns.
Outlook
We remain optimistic about stocks and bond returns over the next year. Earnings growth is expected to be between 11% and 12% for S&P 500 companies in 2024. Corporate earnings growth is the biggest driver of long-term stock performance. These growth rates are above average and should support stock prices.
Expected returns for bonds look positive in the near term. Short and long-term interest rates are expected to peak in the next six months. The higher yields we are seeing today should support bond returns because of elevated interest payments. The Fed is pledging to keep rates at their current level well into 2024, but at some point next year there is a high probability that they will cut rates which will help bond prices rally. When interest rates drop, bond prices increase, and vice versa. Inflation is continuing to improve, and the Fed’s preferred inflation metric has been in the high 2% range for the past three months. This should provide the Fed with confidence that they can start to trim rates next year. The Fed has a 2% long-term inflation target.
The economy has sailed through this year but is facing higher interest rates, auto strikes, the restart of student loan payments, and rising oil prices. None of these are a big deal on a stand-alone basis, but together could damage the already cooling economy. Fortunately, some of these issues, like the auto strikes, should be resolved quickly. Consumer spending is more likely to be impacted by the return of student loan payments and higher energy prices. Inflation has squeezed the wallets of Americans, but as long as people have jobs they will continue to spend. Unemployment continues to be below 4%. Lastly, it’s important to highlight the lag effect of higher interest rates on economic activity. It can take time for the impact to be felt. At this point, the economy has navigated the higher interest rate environment better than expected. We’ll continue to monitor these issues and their possible impact on corporate earnings and economic growth.
Despite the recent market fluctuations during the last quarter, several seasonal patterns should inspire confidence in stocks as we approach the year's end. Historically, when stocks experience a soft performance in August and September, it often paves the way for a strong year-end rally. Since 1952, there have been 13 instances of stocks selling off in these months, and in 12 of those 13 years, stocks rallied in the fourth quarter with an average return of 7%.
As of now, the S&P 500 has gained 12% this year. In years when it has gains of between 10% and 20% by September 30th, the market has performed positively in the fourth quarter 82% of the time. Additionally, when analyzing the final quarter before the presidential election years, there has been an average gain of 3.5%. While these trends are rooted in historical data, they offer reasons for optimism as we approach the end of the year.
Andrew Comstock, CFA