Q3 2023 Market Commentary

October 10, 2023

The third quarter of 2023 saw the euphoric optimism that propelled the “Magnificent Seven” stocks and broad indices higher, abruptly give way to renewed concerns regarding the Federal Reserve's policy action, or future inaction. The initial vigor of July, extending the strong uptrend from the first half of the year, gave way to a notable shift in sentiment during August and September. Historically known for seasonal weakness, these months lived up to their reputations, marking a pronounced reversal.

The primary cause for this correction was not the health of the labor market, consumer dynamics, or the overall economy, all of which remained robust. Instead, the focal point shifted back to concerns surrounding the Federal Reserve’s policy trajectory. What unnerved investors was not merely the prospect of additional rate hikes, but rather the establishment of a "higher for longer" interest rate environment without the anticipated easing of monetary policy that many had expected.

Anticipated rate cuts in 2024 were already factored into the pricing of both stocks and bonds. The need for substantial readjustments in response to these new expectations set in motion a recalibration process for investors. This recalibration resulted in higher rate projections across a longer time frame, which in turn, triggered a correction in asset values.

Domestic Equities

US Equities entered the third quarter strong, buoyed by widespread bets on a soft economic landing and pivot by the Federal Reserve. However, as we progressed through the dog days of summer, investors quickly began to take their chips off the table, reacting to hotter than expected economic data and hawkish rhetoric from the Fed. The realization of prolonged higher interest rates than initially anticipated permeated the market, leading to the first substantial selloff since the banking crisis earlier in the year.

Nearly all sectors felt the impact, with Energy being the notable exception after oil prices climbed towards $95 a barrel following OPEC+ production cuts. Energy (+12.2%) was the top performing sector while interest rate sensitive areas like Utilities (-9.2%) and Real Estate (-8.9%) suffered the most. Mega cap names, whose outsized weight in major indexes can mask strength and weakness in the broader market, dragged down index returns for the quarter. This marked a distinct departure from the storyline of the first half of the year when these mega-cap stocks carried the market higher. The S&P 500 fell 3.3%, the Nasdaq dropped 3.9%, and the Dow Jones Industrial Average lost 2.1%.

In Fed news, Jerome Powell & Co. increased rates by 25bps in July before pausing and maintaining them at 5.5% in the meeting just a few weeks ago. What surprised investors was the updated interest rate projections, famously known as the dot plot. The revised dot plot unveiled that the majority of voting members foresee one more interest rate hike this year, signaling a commitment to maintaining these heightened rates for an extended period before contemplating any potential cuts. This stance diverged sharply from the expectations of many market participants who had been anticipating rate cuts, injecting an element of concern into the equity outlook.

The Federal Reserve's decision to keep rates elevated, even opting for hikes, aligns with the backdrop of economic data outperforming expectations, especially in the service sector, while grappling with persistent inflation. Despite a recent downward trend in inflation, the latest readings indicate a stall in that decline. In fact, inflation witnessed its most substantial increase of the year last month, with the CPI up by 3.7% from a year ago. The Fed remains committed to bringing that figure closer to the 2% mark.

Shifting our attention to the labor market, signs of a slowdown are becoming evident, as the unemployment rate increased by 0.3% to 3.8%. Still, job openings remain plentiful, and wages are increasing. Notably, the Institute for Supply Management's (ISM) manufacturing index remains entrenched in contraction territory for the 10th consecutive month, presenting a contrasting picture to the expanding trend observed in the services sector. The intricate interplay of these economic indicators paints a nuanced picture of the uncertainty facing investors in this dynamic market landscape.

Domestic equities posted another strong performance on the index levels as mega-cap, growth, and AI related names fueled a rally. Throughout this year, the index has been driven in large part by the most heavily weighted names by market capitalization as they contributed nearly 11% of the 14% YTD returns on the S&P 500. For the second quarter, the tech-heavy Nasdaq rose 12.8% compared to the S&P 500’s gain of 8.3% and the Dow Jones Industrial Average’s gain of only 3.4%. To further the point, 8 of 11 sectors underperformed the S&P 500 as Technology (+16.9%), Consumer Discretionary (+14.3%), and Communications (12.8%) were the only outperforming sectors. By contrast, Utilities (-3.3%), Energy (-1.8%) and Consumer Staples (-0.2%) were the biggest laggards.

At the latest Fed meeting a few weeks ago, the committee voted on their first pause in interest rate hikes after ten consecutive increases. Inflation has fallen rapidly to 4%, although that level remains well above the central bank’s target. The Fed has expressed a wait and see approach to lessen the risk of a larger slowdown given the lag effect in monetary policy. Given that economic data continues to surprise to the upside, supported by the services sector, it is very likely that rate hikes, not cuts are the base case for the rest of the year which makes the recent decision a “hawkish pause”.

Other economic developments: Manufacturing PMIs remain in contraction territory since the end of 2022. Q1 GDP growth was revised up to 2%, substantially more than the previous 1.3% estimate. The unemployment rate increased to 3.7% from 3.4%.

Foreign Equities

The MSCI ACWI ex-USA index declined 3.9%.

Eurozone

Eurozone shares dipped more than their domestic counterparts, largely due to the same concern; rising interest rates hampering economic growth. Last month, the European Central Bank announced its 10th consecutive hike as inflation remains more elevated than the US. Further hikes could be off the table as the ECB adopts the Fed’s wait and see playbook due to recent economic data. The latest inflation read showed a decrease to a 2-year low of 4.3% in September from August's 5.2%.

PMI data indicated the eurozone is still in contraction even as the composite reading slightly improved to 47.1 in September from 46.7. Among the sectors experiencing notable declines, consumer discretionary underperformed the market due to worries about the impact of higher rates on consumer spending. Contrastingly, like the US, the energy sector stood out with gains, benefiting from higher oil prices. Overall, the MSCI EAFE index fell 4.1%.

The Bank of England halted its series of interest rate hikes last month, attributing the decision to a decelerating economy. Despite the revelation that the UK economy expanded by 0.2% in the second quarter against the consensus expectation of zero growth, forward-looking indicators signaled a deterioration in economic activity. The BOE revised its growth forecast downward to a mere 0.1%, a significant adjustment from the previous estimate of 0.4%. Inflation in the UK continues to stand notably higher than its developed counterparts, reaching 6.7% in August. This economic backdrop contributed to a 1.8% decline in the MSCI United Kingdom index.

Japan

Japan showcased resilience compared to its global counterparts, buoyed by robust domestic demand. However, rising rates globally impacted larger cap growth stocks. Quarterly earnings showed solid figures as the revision index for estimates remained positive. The MSCI Japan index was down 1.5%.

Unfamiliar for Japan in decades past, inflation has consistently surpassed the 2% target for over a year. In response to this positive economic momentum, the Bank of Japan (BOJ) has hinted at the potential cessation of negative interest rates by year-end. Currently operating short-term interest rates at -0.1% as part of its negative rate policy, the BOJ also places a cap around zero on the 10-year government bond yield. These measures are strategic components of the bank's overarching plan to revitalize the economy and achieve its target sustainably. Notably, Governor Ueda of the BOJ has emphasized the importance of maintaining accommodative policies until the bank is thoroughly convinced that inflation will remain around the 2% mark, substantiated by strong demand and wage growth. This cautious yet optimistic approach underscores Japan's commitment to promoting economic strength.

Emerging Markets

Despite a strong start out of the gates, Emerging Markets faded and finished in negative territory. The retreat was fueled by concerns regarding the enduring strength of the US economy, which hinted at sustained higher interest rates. Additionally, anxieties about China's economic fragility and a strengthening dollar played contributing roles in the sell-off toward the quarter's close. The largest part of the index is China (-1.8%) and it underperformed as economic indicators point to a lackluster recovery. Their property sector problems resurfaced, and policy stimulus continues to have limited effect. Elsewhere, the biggest underperformers were Poland and Chile. One bright spot has been India as it was up 2.9 % for the quarter.

Fixed Income

The bond market claimed center stage during the third quarter’s market correction as yields rose sharply across the globe. As the Federal Reserve and global central banks continued tightening policy, the majority of central bankers are looking ahead and foresee a prolonged period of elevated interest rates. These expectations for higher rates led to a painful deterioration in bond values. The Bloomberg Global Aggregate Index lost -3.6%.

US Treasuries

In the face of the Federal Reserve’s extensive policy tightening efforts, the US economy continued to forge ahead, providing the Fed impetus for sustained policy restriction. While the FOMC paused at September’s meeting, the Dot Plot revealed expectations of elevated policy rates. The revelation triggered a surge in interest rates across the yield curve in the subsequent weeks, propelling the 10-year rate to climb nearly 100bps from 3.81% at the start of the quarter to 4.6%. This shift represents a significant change in expectations and has inflicted considerable damage on treasury bond values.

Notably, the yield curve steepened significantly towards the end of the quarter. This shift reflects diminished concerns about short-term rate hikes, with attention pivoting towards the prospect of sustained higher rates and broader questions about economic stability. This steepening caused shorter-term bonds to outperform their longer-term counterparts. The Bloomberg Treasury 5-10 Year Index lost -3.1%.

Corporate Credit

Although corporate bonds also struggled, the US credit market outperformed compared to treasuries primarily because of its lower sensitivity to interest rates. Spreads remained virtually unchanged throughout the quarter, seemingly showing no significant shifts in expectations regarding credit issues faced by companies. However, spreads initially tightened for most of the quarter, only to rapidly widen, indicating growing concern among investors toward the end of the quarter. Within the corporate market, high-yield bonds outperformed investment-grade due to their shorter duration and higher coupon rates. The Bloomberg US Corporate Bond Index lost 3.0% while the Bloomberg US Corporate High Yield Index returned 0.5%.

Global Bonds

During the quarter, both the ECB and the Bank of England implemented policy rate increases, but with different results for their respective government bond market’s performance. Germany's 10-year yield, considered Europe's benchmark rate, experienced a significant rise, causing European bonds to struggle. Conversely, in England, signs of slowing economic data resulted in relatively flat performance for Gilts. Meanwhile, the Bank of Japan maintained its ultra-loose policy, but allowed for more flexibility in yields within the bond market. As a result, yields on ten-year bonds reached 0.8%, the highest level since 2013, sparking a bond selloff.

Alternatives

Traditional Commodities

Traditional commodity markets etched in a substantial rally in Q3. Oil recorded its strongest quarter of the year, boasting a 22% return. This surge was fueled by an OPEC+ agreement to cut production, which reduced expected supply, causing a spike in energy prices. The S&P Precious metals index fell 3.8% and the S&P Industrial metals index rose 3.5%. Agricultural products experienced an overall decline despite gains from cotton and sugar.

Private Credit

Private Credit continues to be a growing portion of private markets. With interest rates at twenty-year highs, credit is again having its day. Funds with new capital to deploy can take advantage of the increasing yields and the pullback of firms that are experiencing issues in their 2020 – 2022 vintage portfolios, reducing their appetite for new loans. Regional banks continue to face similar issues in their legacy portfolios. Lenders that can move quickly to underwrite new loans and provide confidence of closing to borrowers are able to command a premium and receive equity upside. There is significantly less competition than in prior years and allocators should continue to evaluate and underwrite managers that have a history of disciplined underwriting and returning capital to Limited Partners.

Private Equity

Fundraising in Private Equity has slowed as investors turn towards credit investments that are able to generate mid to high teen net returns. With multiples lower than in previous years, the PE managers that stuck to their underwriting process and did not chase deals are seeing significantly more opportunities. Attractive PE managers have continued focus on smaller scale funds (generally <$2B) where they are sector specialists, have a competitive advantage in the area they are investing, an investment team that has significant experience working together, and a history of returning capital to Limited Partners.

Digital Assets

Cryptocurrencies struggled in Q3 as headlines were dominated by US regulatory action. Bitcoin and Ethereum both fell by 11.5% and 13.5%, respectively. Crypto firms won several high-profile court cases against the SEC, increasing the likelihood that a Bitcoin ETF is approved in Q1 of 2024. Additionally, in early October several Ethereum Futures ETFs were launched, potentially providing a new way for institutional investors to gain exposure to crypto.