Equity markets sold off in the third quarter, as economic growth surprised to the upside and capital markets began to factor in higher interest rates for longer. The S&P 500 finished the third quarter still up 13.06% for the year. The Technology-heavy NASDAQ led the market recovery up 27.11% through September, while the DOW Jones Industrial Average was up only 2.73% through the third quarter. The Russell 2000 Small Cap Index was up 1.35% over the same period. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed the third quarter up 7.63% in US dollar terms and up 10.67% in local currency. The MSCI Emerging Markets Share Price Index closed 3Q2023 up 2.07% in US dollar terms.
2022 saw high valuation technology, internet commerce and growth shares in general lag the overall market. The first three quarters of 2023 saw these same sectors, hit hardest in 2022, post the strongest recovery on optimism for the rise of adoption of AI technology. S&P 500 sector results through 9/30/23: Communication Services 40.4%, Technology 34.7%, Consumer Discretionary 26.6%, S&P 500 13.06%, Energy 5.98%, Industrials 4.49%, Materials 2.61%, Financials -1.65%, Health Care -4.09%, Consumer Staples -4.76%, Real Estate -5.51% and Utilities -14.4%. Subtracting out the tech stock rally, equity markets made little ground during the first three quarters of the year, as returns were concentrated in 2022’s laggards, while value, defensive, and interest-rate sensitive stocks sold off.
Based on current consensus earnings forecasts, the forward 12-month P/E ratio for the S&P 500 is 17.9X, more expensive than the ten-year average P/E of about 17.5X. Currently, the market is estimating 1.1% earnings growth on 2.4% revenue growth in 2023. Much of the recent rally in the equity markets has been liquidity driven. Investors have put high cash levels back to work as the economy and corporate earnings have remained more resilient than worst case fears as a recession expected in the first half of 2023 has not yet materialized. Currently, third quarter annual earnings growth is estimated to be flat with the prior year, after 3 quarters of negative earnings growth and possibly marking the end of the corporate profit recession. The current consensus calendar year 2023 S&P 500 earnings projection hinges on earnings growth returning to high single digit year over year growth by the fourth quarter. In short, equity markets are positioning for a trough in corporate earnings to occur this quarter with better growth prospects returning in the last quarter of 2023 into 2024. The recent selloff in the stock market is factoring in some material negative hit to valuations and earnings as interest rates have moved up appreciably since the end of the summer months. For now, equity markets feel that the severity of any future recession has lessened over the course of this year.
During their September 2023 meeting, the Federal Reserve paused on further interest rate hikes, while also indicating that one or two more 25 basis points rate hikes were expected over the last months of 2023 into 2024. Through September, the Federal reserve has initiated eleven interest rate hikes, as the fed funds rate now sits at 5.25%-5.50%, the highest since 2007. Latest economic projections show an economy that is slowing following unprecedented stimulus during the pandemic. GDP grew 5.9% in 2021, 2.1% in 2022 and is estimated by the Fed to be 2.1% in 2023, revised up from .4% GDP growth estimates assumed earlier in the year. GDP accelerated in the first and second quarter, coming in around 2.5% in June and providing evidence that monetary policy is not yet restrictive enough. As measured by the Consumer Price Index, inflation ended the third quarter at 3.7%, down from 6% in first quarter, and appreciably below the 40-year high of 9.1% in June of 2022. However, much of the decline in inflation numbers has been the result of the rapid decline in oil and gas prices from the summer of 2022. In the third quarter, with oil prices rising from $70/barrel to $90/barrel following stronger GDP growth and OPEC supply cuts; the Fed indicated the need to keep short rates much higher than earlier projections. Current forecasts are predicting a Fed Funds Rate around 5.75% by the end of 2023, 50 basis points higher than fourth quarter projections. More concerning to financial markets, the Fed surprised markets with year-end 2025 Fed Funds rates now estimated above 4%. Both the stock and bond markets have not reacted favorably to this news. While tighter financial conditions have hit parts of the economy, the labor market and consumer spending have remained much more resilient than what the Fed had hoped for earlier in the year.
The 10-year treasury staged a significant correction through September of 2023; starting the year at 3.88% and ending the third quarter at 4.57%. Current intermediate treasury rates are now back to levels last seen in 2007. Longest duration bonds underperformed shorter duration issues as yields moved higher across all maturities. Long treasuries were down 8.55% through the first 3 quarters of 2023, while intermediate treasuries earned .28%. In a risk-on trade, higher credit quality underperformed the lowest credit quality issues. Aaa rated bonds within the Barclays U.S. Aggregate Index were down .34% in the first three quarters of 2023, while Baa rated bonds earned .55% during the same period.
The Bloomberg Dollar Spot Index strengthened 1.63% through September of 2023, as domestic interest rates moved higher in the US vs. our trading partners lower interest rates. Light crude oil futures rose dramatically in the third quarter, now up 12.7% in 2023 as OPEC and Russia cut back production targets. WTI oil futures rose to $90.79 at the end of September from $80.45 at the end of the year. 30-year mortgage rates rose from 6.66% at year-end 2022 to 7.74% at the end of September, while 30-year treasuries rose 73 basis points from 3.97% at year-end 2022 to 4.70% at the end of the third quarter.
According to the Bureau of Labor Statistics, the August employment report showed 187k jobs gained during the month. This was slightly above estimates. The August jobs number reported unemployment at 3.8%, slightly above the February 2020 pre-pandemic rate of 3.5%, a 50-year low. The labor force participation rate in August was 62.8%, up from the pandemic trough of 60.2% in April of 2020. For August, hourly earnings rose 4.3%, below the recent wage inflation numbers averaging greater than 5% and indicating a slight cooling in wage inflation. The still hot jobs market, despite the Fed’s hiking policy, is keeping pressure on the Fed to raise rates higher. However, the recent jobs number showed the first signs of a labor market finally returning to reality.
Retail sales in August increased .6% from the prior month, better than estimates for a .5% increase as consumers were hit with higher gasoline prices at the pump. Annualized retail sales were up 3.6% over the past year compared to the consumer price index’s measure of inflation up 3.7%. Gasoline station sales’ hit to discretionary spending was a 5.2% increase from the prior month as oil prices rose following OPEC+ production cuts. Department store sales were down 3.4% from the prior year. E-commerce and mail-order houses ended the 12-month period with a 7.2% sales gain. Auto sales were up 4.1% from the prior year. Restaurant spending was up 8.5%, furniture store sales were down 7.8%, health care spending was up 7.8% and clothing and accessories were up 1.3%. On a positive note, food costs were up 2.1% from the prior year, well below current year over year inflation numbers as supply chains are recovering from the pandemic. Despite a return to spending on restaurants and services since the pandemic shutdowns concluded, we expect real consumption growth to slow over the coming months, especially for big-ticket items related to housing. However, consumer spending on discretionary items remains resilient and better than most estimates coming into the year.
Equity markets posted negative returns in the third quarter as rising interest rates took some steam from the 2023 equity rally. The most anticipated recession in economic history has yet to materialize. While odds for a recession are still elevated, especially in 2024, the current labor market and employment levels support a softish economic landing narrative. While we still believe that the AI tech stock rally has probably run to an extreme; it is important to note that this year’s concentrated growth rebound still places the NASDAQ 18% below the highs of 2022. Through 2022 and three quarters of 2023, the only positive economic sector has been energy stocks with the S&P 500 still down roughly 12% since market highs on January 3, 2022. In short, equity market levels are trading at roughly the midpoint between January 2022 market highs and October 2022 lows. We see equal odds for single digit gains or losses for equity markets moving forward. While growth valuations are elevated, small capitalization domestic equities and international stocks are trading at large valuation discounts to the mega-cap technology stocks that have led the market out of extremely bearish sentiment levels. The key to a bottom in this equity correction will be stabilization in the extreme volatility that interest rates have experienced since August of this year. Since August 1st, the 10-year treasury has risen from 4.1% to 4.74%, and the S&P 500 has corrected 7% following this move in interest rates as investors are starting the believe the Fed’s intentions to keep interest rates higher for longer.
Within the fixed income markets, March of 2022 initiated a major shift in Fed policy as interest rate liftoff began in the first quarter of last year and is now close to a pause in the feds interest rate tightening program. However, this pause does not indicate that rates are moving lower anytime soon. With core inflation currently running around 4.3%, we expect the fed funds rate to end 2023 around the Fed’s telegraphed rate of 5.50% to 5.75%. Inflation is remaining sticky while economic growth and tight labor conditions are still not restrictive enough for the fed. While interest rates fell during the first quarter of the year and the bond market was pricing for recession and interest rates cuts in 2023; the bond market rally has evaporated and investors are now seeing a much tougher road to moving inflation back down to the fed’s 2% target. Following these developments, the 2-year treasury started 2023 at 4.43% and has risen to 5.05% today (October 4). The 10-year treasury has risen from 3.88% at year end to 4.74% today, while the 30 year treasury has risen from 3.97% to 4.88% today. The Fed now sees the fed funds rate hitting 5.50-5.75% by year end 2023, while remaining above 4.0% well out to 2025. The Moody’s Seasoned “A” Corporate Bond yield, currently at 6.02%, is at the highest levels seen in a decade, right back to the peak in interest rates that occurred in October, 2022. In our opinion, the fixed income markets still offer yields that provide an alternative to equity only investing that has not presented itself in the last decade’s low interest rate environment and would provide a hedge to any severe equity market correction and recession selloff. In such a scenario, the Fed would lower rates sooner and bond prices would provide some cushion to any equity losses.
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Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.