This article is brought to you in collaboration with our colleagues at Laird Norton Wealth Management from their post, Economic Flash: Signs of Slowing in Job Market, Consumer Spending.
U.S. Economy: Less Optimism
While headline unemployment dipped to 3.5%, most indicators underscored labor market cooling. Among them: a drop in current job openings (to 8.8 million); fewer small businesses planning to hire (17%) and fewer people quitting their jobs (3.5 million in July), bringing each of these indicators to their lowest level since early 2021. Meanwhile, higher borrowing costs erased a summer spike in consumer confidence, the sharpest contraction in two years.
U.S. Stocks: Waiting on the Fed
U.S. equities fell modestly but stayed in the black for Q3 through August, with more economically sensitive small-cap stocks the weakest performers. Higher interest rates and tighter bank lending standards are now being felt more keenly by consumers and businesses. Consequently, investors are wary of another Fed interest rate hike, which may not happen in September, given recent Fed comments and weaker economic data.
Foreign Stocks: Concern About China
International equities have generally mirrored U.S. equity markets, with many economies facing similar challenges, including inflation. The outlier is China (-9.0%), which is facing capital outflows amid deflation, weaker growth, high levels of business/consumer debt, and structural youth unemployment. Conversely, India and Mexico seem to be early beneficiaries of the near- and friend-shoring trend we have been discussing for some time.
Fixed Income: Short Maturities Rule
Since May, interest rates have resumed their climb. The yield on the U.S. 10-Year Treasury note is nearly at the peak hit late last year (4.2%) amid expectations that the Fed will have to keep its target interest rate elevated for longer. With that backdrop, shorter maturity bonds and some higher-yielding corporate bonds outperformed, while arguably overvalued municipal bonds came back to earth somewhat.
Real Assets: Commodities Hold Up
As with equity markets, most types of real assets posted weak or negative returns in August. Commodities were the strongest relative performers, despite an environment characterized by global economic weakening: The energy subcomponent was up 2.4% on tighter crude oil supplies. On the fixed-income side of the asset class, Treasury Inflation Protected Securities (TIPS) fell given the rise in interest rates.
Alternatives: Riding the Turbulence
Hedge funds were among the strongest performers as both traditional stocks and bonds finished August in the red. Absolute return-oriented strategies (+0.7%) often perform well in environments with higher volatility, which was the case for the bulk of August. Market directional hedge funds (-0.5%) were an exception, although they remain the best-performing alt strategies so far in 2023, given strong global equity results.
Source of data: Bloomberg
Equities Total Returns
Fixed Income Total Returns
The game of tug-of-war playing out in the economy and financial markets (contraction vs. expansion), which we have highlighted in recent commentaries, remained in stalemate in August, although an argument could be made that the forces of contraction gained a small amount of ground.
While consumer spending showed a robust increase in July over June (+0.8%), the data as we enter Fall make for a less rosy scenario, including: Cooling in the labor market and wage growth, which has been steadily falling from the multi-decade peak hit in June 2022, and deterioration in consumer confidence, something that materialized quite quickly.
Meanwhile, the Fed’s preferred inflation gauge (the Core PCE) has risen over the past two months at the slowest pace since 2020. That pace annualized would amount to U.S. inflation of 2.4%, close to the Fed’s target of 2% and a welcome respite from much higher inflation in 2022-early 2023. Still, the price paid for lower core inflation is often a weakening economy.
So far, the U.S. economy has avoided a drop-off in economic activity, as growth in services makes up for the sluggish manufacturing sector. Prior to August, the financial markets certainly benefited from consensus sentiment that a severe recession would be avoided. That said, the focus of investors continues to be how much the economy will slow down, given that the cost of credit for consumers and businesses is a key variable in economic growth.
Impact of Higher Rates
When interest rates rise steeply, as they have been since March 2022, borrowing money to spend or invest becomes more expensive, curbing economic growth. Look no further than mortgage rates. Two years ago, a $500,000 mortgage at 2.8% would have a monthly payment of $2,054. Today, that same mortgage at 7.5% would cost 70% more, or $3,496 a month.
While the impact on the housing market so far has been muted due to low supply, higher borrowing costs are hitting consumer auto and credit card payments and business lines of credit and other financing. Accelerating erosion in the creditworthiness of credit card holders was a key theme in recent earnings reports coming from many notable retailers.
Also, recent employment data indicate an increase in part-time work and people holding more than one job (double counting). Meanwhile, the average hours worked per week continues to fall. If you adjust for the contraction in the workweek, there has been no job growth at all this year, resulting in an unemployment rate that is closer to 4% than the 3.5% reported.
That we haven’t seen more substantial cooling is likely due to the extended era of low fixed interest rates on mortgages and personal credit, coupled with businesses’ high cash holdings. The impact of Fed policy plays out a bit like steering a boat rather than driving a Toyota Prius: You have to arrest your turn before you are pointed in the direction you want to go. Said another way, Fed policy always comes with a bit of lag.
What does this mean for investment portfolios? Well, it doesn’t mean that we are necessarily in an unfit environment for investment even if the economy does sour a bit from here. Our portfolios are built with client strategic objectives in mind and to withstand the ebbs and flows of the economy and financial markets.
This could be an opportune time, depending on your specific goals, objectives and risk tolerance, to rebalance public equity risk in favor of private equity, private credit, and/or hedge funds, all of which are currently among our strongest conviction allocations for long-term goal attainment. Our investment team is constantly surveying the landscape for timely opportunities, and it is often in the periods of uncertainty or volatility, and in the less travelled corners of financial markets, where we can source the most interesting new strategic positions.
Broadly, corporate credit of various types is an area we are watching closely. Specifically, we are monitoring debt strategies within the commercial real estate market, which is facing an evolution in the usage and demand for real estate alongside the aforementioned rise in financing costs. This includes the peripheral markets around bank lending, including CLOs (Collateralized Loan Obligations) and private debt strategies, which are poised to fill the void created by tighter banking standards. Last but certainly not least, as we have been stating for some time, you are now (finally) getting compensated for owning investment-grade fixed income. Depending on the risk-return profile required to achieve your life goals, a higher allocation to fixed income for yield and stability could make sense.
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.