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SUMMARY
- Fed reinforces its current narrative of higher rates for longer.
- Negative returns and higher yields in Q3 despite strong earnings…
- …which keeps us overweight stocks.
Quarterly Recap: Inflation is Improving, and Earnings are Strong, but the Fed’s Interest Rate Path is Unchanged; this Led to a Disappointing Q3 for Investors
After two quarters of strong markets, the third quarter started on an optimistic note; inflation had been declining and earnings were holding in. However, this optimism didn't last; both stocks and bonds had negative returns in Q3, despite declining inflation and strong earnings. This quarter reminded investors that markets look ahead and not in the rearview mirror, and short-term prices are often driven by how data surprises relative to expectations.
In this quarter, the dominant surprise for the market was the Federal Reserve’s tone, in our view. According to probabilities implied by bond pricing, consensus viewed rate cuts as likely, potentially starting as early as Q1 2024. The combination of a summer rally in oil and inflation remaining higher than expected led to a clear and unambiguous message from the Federal Reserve that suggested rates would remain higher for longer.
Bond yields rose markedly throughout September as the Fed’s message of “higher rates for longer” became reflected in prices, a trend that has continued unabated into the first week of October. Stock markets in the near-term implicitly price off interest rates, both from a profitability viewpoint as well as from a valuation one. With regards to profits, interest costs detracted from profits, thus the message of “higher for longer” overwhelmed what appears to us to have been a pretty good Q3 earnings season. From a valuation multiple standpoint, higher rates tend to make stocks less attractive relative to bonds and cash. All of this took what might have appeared from a distance as ‘good news’ (lower inflations, improving growth, improving earnings) and turned it into a challenging third quarter.
Returns Recap:
The quarter created a tough environment at the asset class level, with Cash and High Yield Bonds being the only two segments with positive returns. Emerging markets, while still the lowest performing equity market over the past 12 months, performed slightly better than the other broad markets during the quarter, in large part due to their elevated commodity exposure relative to the other major broad equity market segments. Small caps, which have arguably the highest sensitivity to US rates, fell the most of all major segments, and developed International and US equities were in the middle. The good news is that the longer-term positive technical trends are still intact for US markets, in our opinion (see last’s week’s Weekly View), although all of the markets are now more susceptible to rollovers in momentum.
US Sectors: Energy Rides the Oil Wave; Comm Services Leads a Weak Growth Pack
Looking at US sectors, the major differentiator of performance appeared to be rising costs of capital, skepticism about tech-related earnings that were not immediately evident, and a lift from oil prices. Energy was the leader due to solid earnings in the sector coupled with a tailwind of rising oil prices. The two largest communications services companies displayed unexpectedly strong profitability against a backdrop of angst around valuations of technology which we believe drove this sector to positive returns. Defensive sectors struggled under the weight of rising interest costs, with consumer staples, utilities, and real estate amongst the worst performing sectors.
International: Developed Markets still lead Emerging Markets
A look at specific international markets uncovers a few themes. China, while still the weakest market year over year, held up better than every market in the table below except Japan and the UK, and its primary reason for being negative for US investors was weakness in the yuan. More generally, the major themes that drove international returns appeared to be Energy and Value, which favored the UK, Japan, and China. While Canada has a large contingent of energy companies, its banking and materials companies struggled, making Canada an outlier among commodity producers.
Forward Outlook: Remain Constructive on US Stocks; Markets Likely to Remain Range-Bound in Near-Term
The third quarter proved to be a sharp departure from the first half of the year, and the beginning of Q4 appears to be a continuation of that trend. We continue to see markets trending towards a version of our ‘Base’ case from our 2023 Outlook, in which the US economy slows some but stays solidly positive, and inflation also moderates but persists at a higher level than pre-pandemic averages.
In this scenario, we foresee the Fed will be proven correct and interest rates will likely need to go higher to combat inflation. If this plays out, we think equity investors should expect volatility and range-bound markets between 4200-4600 on the S&P 500 in the near-term, before resolving to the upside at some point, likely in 2024. This is an environment where we believe the ‘P.A.T.T.Y’ theme (‘Pay Attention to the Yield’ - a focus on investments with strong yields and free cash flows to support them) would be an effective strategy.
Importantly, a PATTY strategy is not the same as a high dividend strategy. Dividend stocks have underperformed significantly in 2023 due to their sensitivity to rising interest rates. The PATTY theme, on the other hand, is about companies that can generate significant current earnings and cashflow yields, which may or may not be paid out in dividends (see July Weekly View on P.A.T.T.Y. and September Weekly View on High Dividend Yielding Stocks). We think total returns for these types of companies will continue to move higher over time, due to more resilient earnings and cash flow.
In conclusion, we continue to slightly favor stocks over bonds in our balanced portfolios. We currently favor US stocks across our balanced portfolios and are tactically becoming more cautious on international.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.