U.S. Economy: Treat or Trick?
The U.S. economy grew a stellar 4.9% (initial estimate) in the third quarter, generally beating economist expectations. Driving U.S. growth was a spike in consumer spending, increases in government spending and a buildup in business inventories. Doubts about robust growth continuing center on high U.S. interest rates, the drop in inflation-adjusted wages, and a dramatic decline in the savings rate.
U.S. Stocks: Market Jitters
U.S. stock markets lost ground for the third straight month. Investor optimism in the first half of October dissipated as interest rates generally resumed climbing and the ramifications of high interest rates on both personal and business credit markets weighed on sentiment. The energy (-6.2%) and consumer discretionary (-5.2%) sectors were the weakest performers amid fears of an economic slowdown. The so-called “Magnificent Seven” stocks (Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla) (-3.0%) held up a bit better.
Foreign Stocks: Also Down
International stocks did not fare much differently than their domestic counterparts. Nearly every sector of foreign developed equity markets fell. Likewise, no country was particularly accretive to returns. Japan (-3.7%) and the UK (-3.9%) pulled down results the most, on rising rates and monetary policy uncertainty in Japan and deteriorating labor market and business activity data in the UK.
Fixed Income: Higher Yields Hurt
Interest rates moved higher swiftly, with the U.S. 10-year Treasury yield touching 5% before settling at 4.9% by the end of October. Less interest rate sensitive corners of fixed income were the strong relative performers, with municipals (-0.3%) and high yield bonds (-1.4%) “leaders.” Meanwhile, corporate stress is showing up in the high-yield bond market with the yield spread to Treasuries up 0.7% since mid-September.
Real Assets: A Glimmer From Gold
Gold (+7.2%) was the only real positive for real assets in October, as the Israel-Hamas war created yet another geopolitical hotspot. With that backdrop, investors have sought gold as a “safe haven” along with other precious metals. Similarly, other more defensive corners of real assets such as infrastructure equities (excluding oil and gas pipelines) provided some ballast to portfolios with modestly negative returns.
Alternatives: Hidden Opportunities
The private markets have not been immune to the repricing of risk due to higher interest rates, although hedge funds have incrementally outperformed. The higher cost and scarcity of financing will likely hamper some private equity investments faced with declining profitability. That said, with bank lending constrained, non-bank lenders may be able to lock-in advantageous terms for high-yielding loans from real estate to seasoned private equity.
Source of data: Bloomberg
Equities Total Returns
Fixed Income Total Returns
Summer seemed to end abruptly this year, both literally and figuratively, with frosty mornings and frostier financial markets. In the last few months, sentiment about incoming economic data and Fed policy has shifted much more pessimistically and the geopolitical backdrop has only grown more fractured with the unfortunate developments in the Middle East.
What has changed? From a fundamental standpoint, we do not have new data that suggests a dramatically weaker U.S. economy since the summer started. We have a mixed picture presenting both weakness and strength. On the latter front, 4.9% GDP growth in the third quarter and the low unemployment rate highlight the resiliency of the U.S. economy, something we have pointed to over the last year. Unfortunately, most investors do not realize that relatively strong economic data has preceded many recessions. The prior quarter’s GDP has 0% correlation with growth one or two quarters out. In the past, we have seen growth of 4% or higher during the very quarter that the official recession (per the National Bureau of Economic Research) began.
That the coincident and lagging U.S. economic data have not deteriorated all that much is actually part of the problem. Based on the selloff we have seen in equities and bonds, investors seem to be realizing that Fed policy will likely stay restrictive for longer, and the most obvious consequence of that is that interest rates will remain elevated. In the last few months, longer-term interest rates have risen a bit more quickly than short-term rates, while the derivatives markets are projecting that the Fed funds rate will be higher at the end of 2024 by 70 basis points. The longer that interest rates are elevated, the more difficult it will be for financial markets to avoid disruption as corporate profitability continues to fall and defaults mount.
That stock market performance has hit a rough patch is not particularly surprising, and it could be a self-fulfilling prophecy. Why wouldn’t a savvy investor reduce equity holdings in this type of environment?
We are never keen on projecting near-term results in equity markets, partly because market sentiment tends to be fickle. To wit, in early November sentiment got a boost after the Fed left its target rate unchanged and telegraphed that more time was needed for the impact of previous Fed rate hikes to flow through the economy. Both stocks and bonds reacted positively but not enough to offset losses so far this autumn.
The Case for Bonds
We continue to position portfolios for a more volatile and evolving market regime, created by shifts in the economy to reflect a more multi-polar and fractured world. In doing so, we are focused on two key things: 1) Making sure that the portfolios we have built to attain clients’ long-term objectives are still correctly positioned for those objectives within the context of a more volatile environment; and 2) Continuing to check cognitive and emotional biases that can lead to poor decision-making. Our perspective on one asset class – fixed income — touches on both of these aspects.
Allocating to asset classes that are challenged is often a way to add value. With interest rates and core fixed income yields rising, the longer-term risk reward tradeoff is now much more positive for bonds and credit-oriented investments than it has been in many years. After years of underperformance, we think fixed income is now well-positioned for better risk-adjusted returns, so we are likely to continue adding to this asset class going forward. Similarly, while deterioration in corporate credit is starting to manifest more clearly, the opportunity set continues to increase in that space. Finally, the heightened risk associated with the potential expansion of the Middle East conflict beyond Gaza-Israel, supports the case for core fixed income and diversifiers.
Glossary of Indices
U.S. Large Capitalization = S&P 500 Index
Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.
U.S. Small Capitalization = Russell 2000 Index
Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.
U.S. Growth Equities = Russell 3000 Growth Index
Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.
U.S. Value Equities = Russell 3000 Value Index
Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.
International Equities (Developed Countries) = MSCI EAFE Index
A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
Emerging Market Equities = MSCI Emerging Markets Index
A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
U.S. FIXED INCOME, TAXABLE
U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index
Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).
TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index
Measures the performance of TIPS of various maturities issued by U.S. Treasury.
INTERNATIONAL FIXED INCOME
International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.
Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.
Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign
Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.
U.S. FIXED INCOME, TAX-EXEMPT
Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index
A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.
Municipals, Broad Market = Merrill Lynch Municipal Master Index
Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.
Absolute Return Funds = HFRX Absolute Return Index
Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.
Market Directional Funds = HFRX Market Directional Index
Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.
Equity Volatility = CBOE VIX Index
Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.
Implied Inflation = 10-Yr TIPS Implied Inflation
Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.
Gold Spot $/oz.
An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.
Oil = Brent Crude Oil Spot Price $/bbl
Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.
U.S. Dollar = Trade-Weighted U.S. Dollar Index
Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data.