U.S. Economy: Cooling Inflation, Job Market
The U.S. economy grew 2.1% in Q2, with inflation moderating. For August, the Core PCE index rose just 0.1%, the smallest monthly increase in three years, putting annualized inflation at 3.9%, dramatically down from the highs of last year but still almost double the Fed’s 2% target. Meanwhile, an uptick in the unemployment rate (3.8%), labor strikes, and failure of Congress to agree on a federal budget hurt consumer confidence.
U.S. Stocks: Large Growth Stumbles
U.S. equities fell for the second straight month, making Q3 a down quarter. With economic clouds on the horizon, valuations elevated, and earnings forecasts slipping, even the bulk of the “magnificent 7,” including Apple (-8.9%) and Nvidia (-11.9%), posted losses after driving most of 2023’s gains. As has been the case for much of this year, the more economically sensitive small-cap stocks were the weakest performers overall.
Foreign Stocks: Norway & India Outliers
International stocks outperformed the U.S., but were still down for Sept., with the 2.5% rise in U.S. dollar a drag. While foreign developed markets were almost unanimously down, Norway (+4.9%) was an outlier as oil production boosted energy stocks. In emerging markets, China (-2.8%) is facing a myriad of structural economic problems and potential deflation, while India rallied (+1.8%) as its GDP surged 7.8% year-over-year.
Fixed Income: Short Maturities Rule
Money market funds and short-term fixed income were among the few bright spots in U.S. financial markets, with limited or no interest rate risk the driving factor. The yield on 10-year U.S. Treasury bonds rose nearly 0.5% in September and sits near 4.7% in early October, a level not seen since 2007. With yields up, core taxable bonds fell 2% to 4% during the month, erasing 2023 gains. Mortgage rates (30-year fixed) rose above 8%.
Real Assets: Mixed Bag
The real assets category was not spared the pain felt in other asset classes. The dramatic increase in oil prices (WTI Crude hit nearly $90/barrel) and energy more broadly kept commodities in positive territory, but agriculture, grains, and precious metals were all down in line with equities. The renewable energy sector in particular is being hurt by rising operating costs while locked into supply agreements whose pricing is now below market rate.
Alternatives: Relatively OK
Hedge funds found the middle road between stock and bond performance, modestly outperforming each. Managed futures strategies (+3.6%) were able to capitalize on persistent trends while market directional funds (-1.4%) unsurprisingly struggled a bit with deteriorating sentiment. Looking forward, a backdrop of higher interest rates is a potential tailwind for hedge funds as well as a number of private credit strategies.
Source of data: Bloomberg
Equities Total Returns
Fixed Income Total Returns
With three quarters now on the books, many of the more dire prognostications that economists had for 2023 remain unfulfilled: U.S. economic resiliency continues to surprise, inflation is slipping downward slowly, and the labor market hasn’t deteriorated meaningfully. Will the dire forecasts prove right at some point? Perhaps, since the impact of higher interest rates is finally starting to register.
Instead of focusing on the unknown, we continue to fine-tune portfolios for the likely shift in market regime we have discussed since the beginning of 2022: higher interest rates and inflation vs. the past decade, driven by pandemic and more recent trends that include: an ongoing shift toward reshoring (vs. globalization); U.S. organized labor reasserting its power; and rising uncertainty regarding U.S. fiscal policy as evidenced by the recent vacating of the Speaker of the House of Representatives.
Our approach is not one that leans into short-term bets, opting instead to build portfolios designed to perform through various market and economic environments toward long-term client objectives. The strong equity market in the first half of 2023, or “free lunch” as we called it at the end of June, provided an opportunity for portfolio rebalancing: trimming gains and adding to asset classes that had sold off. After the sell-off in most asset classes during Q3, rebalancing opportunities may be limited. Now is the time to exercise discipline and adhere to strategic asset allocations that target long-term goals, while making incremental adjustments to asset allocation to either reduce risk or increase return potential.
Please see our Q4 2023 Commentary, due out the third week of October, for an in-depth discussion of the major factors we see driving the markets and how we are positioning portfolios as a result.
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.