The month of September erased what had been a decent third quarter building throuh July and August. The simultaneous run up in bond yields and oil prices was a primary culprit. The final result was a quarter that saw nearly all major indexes and asset classes posting negative returns of generally -1% to -4% with certain outliers such as the long-dated US Treasuries down over 10%. October has seen some stabilization, but markets are still volatile and nervous, with good reason: labor strikes continue, student loan payments are due, oil prices keep rising, Chinese real estate is wobbling, and the Ukraine/Russia war drags on. Bond yields continue to creep higher. Stock price movements have been mixed and earnings season is underway.
The terrible human tragedy in Israel and the Middle East has further complicated the world. Our deepest condolences and prayers go out to all of those impacted by war and suffering. We in no way seek to minimize the human impact of terrorism and war when discussing market impacts.
Despite the long list of negative complications mentioned, the economy and the large US corporations that dominate market mood are facing these headwinds from a position of strength and resiliency. The underpinnings of this strong foundation will be tested in the quarters ahead. Client portfolios are prepared with high quality holdings durable for the long haul. As always, we seek to avoid the excesses that have crept into the market during the era of ultra-low interest rates and are now vulnerable going forward.
Our baseline recommendation remains largely the same at the headline level: a small underweight to equities, neutral (market weight) in fixed income and a small overweight to cash as dry powder for new opportunities while patiently earning relatively attractive short-term yields in the interim.
In equities, the S&P 500 was down -3.3% for the third quarter with individual sectors performing in a range of -9.3% (utilities) to +12.2% (energy). Beyond energy’s double-digit return, the only other positive return for a major sector was +3.1% for consumer services. Real estate and utilities stocks were hit hard due to higher rates while energy stocks and oil prices were among the few positive performers.
Dispersion of returns has been profound with the Magnificent Seven (Apple, Meta/Facebook, Amazon, Tesla, Nvidia, Alphabet/Google and Microsoft) vastly outperforming the other 493 stocks of the S&P 500. These top seven stocks have carried the weight of the index and its double-digit positive performance year to date. The other 493 have underperformed cash. There are justifications to this divergence as shown in the table below—the Magnificent Seven have the net income deserving of stock appreciation while the rest of the market does not.
Source: Strategas, 10/17/2023
These mega cap stocks at the top of the market have already run quite a long way. We are tactically adjusting position sizes as appropriate, but we do expect to own some portion of these Magnificent Seven for the long haul given their dominant market share and outlook. Many are high quality, fundamentally sound companies that fit our long-term investment philosophy extremely well. However, we do not advise putting all eggs in such a narrow basket and prefer to pair these positions with other names below the mega cap tier. If the themes and ecosystems attached to these Magnificent Seven are as robust and everlasting as they are touted, then there are undoubtedly other attractive stocks within these orbits.
In addition, by diversifying beyond the largest names, portfolios are able to hold stocks that could be attractive acquisition candidates (as was the case for one of our preferred energy companies recently) and stocks that can grow and mature into tomorrow’s large cap winners and enjoy the price appreciation that can come with being added to the S&P 500 (as was the case for one of our preferred consumer discretionary stocks).
Market consensus is still expecting approximately 12% earnings growth next year for the S&P 500. That type of growth would be quite healthy if it comes to pass. The challenge is that prices already reflect very healthy profit margins, as shown in the table below.
Maintaining and defending these margins could be difficult for companies already facing inflated input costs, higher labor costs and higher interest rates. Layoffs are a way to protect margins, but those employees are also consumers that are needed to keep the economy going. Therefore, though earnings have likely bottomed, we are skeptical that earnings growth will be as robust as currently forecasted, at least in aggregate. Instead, we prefer more active management to seek to identify a smaller subset of durable, quality stocks within the overall market.
Balancing these dynamics, we are slightly underweight stocks versus benchmarks on a macro basis, yet the majority of our current active risk budget (versus benchmarks) remains in US equities due to relative value opportunities on a sector and single stock basis. Current themes in our equity models include generative AI, cyber security, cloud computing, automation/digitization and electrification/clean energy transition as well as select opportunities in healthcare and industrials.
In international markets, Q3 performance more closely tracked the US as the MSCI All Country World Index (ACWI) ex-US Index was down -3.8%. The pullback in international was relatively even and broad based. For the year to date, there has been material dispersion across countries with Brazil up +13.0%, Japan +9.1% and China down -9.0% as a few of the outlier examples. China’s real estate sector remains particularly challenged with its property stocks at their lowest level since 2009 and remain a risk for spreading further contagion. These differences are a primary reason why we advocate for active management and differentiation within international investments for most client portfolios.
Bond markets were down slightly in Q3, much like Q2, with only T-bills and high yield bonds grinding out any positive return. In August, the Fitch bond rating agency downgraded US government bonds to AA+ (from AAA) considering the difficult debt and deficit dynamics as well as the recurring political conflicts in Washington. The era of nearly 40 years of declining 10-year bond yields appears to be over as yields have returned to nearly 5%. The yield curve has also become less inverted as some term premium starts to again be required by investors in longer term bonds.
The silver lining to the march higher in yields is that the market is “doing the Fed’s work for it” and further interest rate hikes might not be needed. Once the Fed stops its hiking cycle, it tends to allow bond prices to recover (and yields to favorably fall) as shown in the graph below.
In credit markets, we are actively debating and monitoring the negative feedback loop of higher funding and debt service costs facing many governments, consumers, and corporations. Though seemingly not as prominent in recent headlines as earlier in the year, items like commercial real estate are still under heavy stress. Even prudent and conservative hedges against rising rates are starting to expire and need to be reset and rolled at much higher costs. Corporate debt once thought to be safely extended out to longer maturities will eventually come due for refinancing. Thus far, there have been no major changes in corporate bond markets other than some minor credit spread widening and early indications of stress that are not yet widespread. We have limited exposure in lower rated credit and are waiting for better opportunities.
We are cautious on the market overall and remain relatively close to benchmarks with geopolitical and economic uncertainty running very high. While we are impressed by the resiliency of the US consumer and the economy thus far, we are picking and choosing our spots based on the ongoing challenges of a higher-for-longer interest rate environment, lofty Wall Street earnings projections and geopolitical tensions. Our specific risk remains mostly in quality US large cap stocks which we consider excellent long-term investments. We complement these core holdings with global diversification as well as robust, high quality bond portfolios. Recent bond returns have been underwhelming but have established better starting yields for the forward horizon that are a viable component of balance portfolios. Bonds predictably failed as an inflation hedge in the last 1-2 years, but they remain a “hedge” to any growth shocks that could be particularly harmful to equities should they arise. Given the uncertain outlook, a cash buffer is also helpful, especially considering that higher short-term yields nicely reduce the opportunity cost of being more patient for better entry points into risk assets.
Our next client conference call is scheduled for November 15th. We hope you can join us.
Jul 18, 2023