Historically, the third quarter has been a challenging period for the equity markets, and the third quarter of 2023 certainly adhered to this pattern. As the quarter progressed, the optimistic outlook held by investors dwindled, with rising concerns and escalating volatility. Worries centered around government and economic uncertainties, persistent inflation, and the looming specter of another rate hike later in the year.
September unfolded as a rather turbulent month for investors, with heightened volatility in the final stretch of the quarter. Late September witnessed a decline in equities, primarily due to the Federal Reserve's decision to abstain from raising interest rates, coupled with the unsettling news of a potential rate hike later in the year and a potential government shutdown. The prospect of enduring higher interest rates did not sit well with the investment community.
As the quarter ended, major indexes found themselves lower than their starting positions. The S&P 500 suffered a 4.9% drop in September, while the Dow Jones Industrial Average (DJIA) was down by 3.5% for the same month. Over the course of the quarter, the S&P 500 experienced a 3.7% decline, marking the end of its three-quarter streak of gains. The index closed the quarter at 4,288, while the Dow Jones Industrial Average (DJIA) concluded with a 2.7% drop, settling at 33,507. (Source: Bloomberg LP; 10/5/23)
During the quarter, the Federal Reserve once again raised interest rates in July in response to a slight uptick in inflation as investors continued to grapple with the prospects of a potential recession in the quarters ahead. However, the U.S. economy remained resilient, boasting a robust job market and high consumer spending confidence. At their September meeting, the Fed chose to maintain the Federal Funds rate range between 5.25% and 5.50% and upgraded their assessment of the economy to "solid" from the previously assigned "moderate" pace.
The labor market remained resilient in the third quarter, with persistent demand for labor driving wage inflation, resulting in real wages surpassing pre-pandemic levels. Unemployment remained below 4% for the 19th consecutive month, a key indicator closely monitored by the Fed.
One setback during the quarter occurred in September when inflation numbers for August posted their most significant monthly increase in 2023. However, a closer examination revealed a deceleration in the core Consumer Price Index (CPI).
In late September, the House of Representatives canceled its planned two-week recess to avert a potential government shutdown, striking a last-minute deal and passing a 45-day stopgap government funding bill, thus averting a potentially catastrophic event on October 1st.
Recent years have shown us that almost anything can happen. As investors, the third quarter serves as a stark reminder that volatility remains a constant presence. Now is not the time for complacency. We remain steadfast in our belief that investing is a long-term commitment. A well-structured, diversified plan centered on the long term can help withstand market fluctuations and economic uncertainties. We recognize that short-term trading and investing can be riskier and less tolerant of market fluctuations and instability, and it may not be suitable for everyone.
THE FED & INTEREST RATES
In their September session, the Federal Reserve opted to maintain the status quo on interest rates, keeping the rate range steady at 5.25% to 5.50%. However, they hinted at the likelihood of another rate increase later in the year. This was attributed to the enduring strength of the economy and a modest uptick in inflation. Fed Chair Jerome Powell emphasized their commitment to maintaining a sufficiently restrictive monetary policy to gradually bring inflation back in line with their 2 percent target, as expressed during the September press conference. They observed, "Recent indicators suggest that economic activity has been expanding at a solid pace. Job gains have slowed in recent months but remain strong, and the unemployment rate has remained low. Inflation still remains elevated." (Source: federalreserve.gov; 9/20/23)
As the calendar turned to September, the release of the Consumer Price Index (CPI) reports for August brought some notable figures. The White House's August 2023 CPI announcement revealed that inflation for the month stood at 0.6%, with a 3.7% increase over the past 12 months, compared to the 8.3% year-over-year inflation rate of the previous August. These figures marked an escalation in inflation rates, with August witnessing the most significant monthly surge thus far in 2023. The primary catalyst for this leap was the substantial spike in gasoline prices, which soared by over 10.6% during the month. This surge in fuel costs, along with rising food prices, continued to strain consumer budgets. It's worth noting that transportation costs, encompassing gasoline, represent the second most substantial expenditure for U.S. households, following housing expenses.
Putting things in context, if you exclude the energy and food sectors, core inflation only saw a 0.1% rise during this period. Looking beyond the surface, the year-over-year percentage change for the CPI, up to August 2023, actually decreased in August when you exclude food and energy.
The Consumer Price Index serves as a metric for tracking the average price changes across a wide spectrum of goods and services. Encouragingly, the core CPI displayed a continued deceleration even in August. The core CPI is considered a more reliable gauge of future inflation trends, and the Federal Reserve relies on this data to inform their strategy for addressing inflationary pressures.
The U.S. economy displayed a mixed performance during the third quarter of 2023, with several key indicators shaping the economic landscape.
As noted above, Inflation remained a central concern as the Consumer Price Index (CPI) showed moderate price increases, driven primarily by elevated energy and food costs. Although these rising costs have implications for consumer purchasing power, they have been viewed by the Fed as more transient and manageable components of the inflation problem. Housing costs on the other continued to put a strain on the consumer’s wallet. Home prices rose by 2% during the quarter on a seasonally adjusted basis with the housing market experiencing limited supply and stable demand despite rising mortgage costs. These factors have challenged housing affordability for many Americans, prompting discussions about potential policy measures to address the issue.
Unemployment figures pointed to a thriving labor market, with the national unemployment rate at a low of 3.8% during the quarter. This demonstrated that employment opportunities were still abundant and contributed to greater financial security for workers. However, wage growth continued to slow to 4.5% leaving less room for consumers to stay ahead of inflation.
GDP growth continued to be a bright spot, with the U.S. economy expanding at a steady pace. According to the Atlanta Fed, their GDPNow estimate for the third quarter real GDP is expected to come in at 5.1%. The GDP growth rate in the third quarter indicated resilience, underpinned by strong consumer spending, solid business investments, and government spending increases.
Consumer confidence surveys did, however, point to signs that consumer expectations about future economic growth could be waning. The Consumer Confidence Index declined again in September to 103 making two consecutive months of decline. This decline in sentiment certainly highlights the concerns that consumers have about persistently high inflation and interest rates. However, this attitude did not necessarily disrupt their consumption habits for the quarter.
In summary, the U.S. economy in the third quarter of 2023 presented a mixed picture. While inflation and housing costs were areas of concern, the economy exhibited resilience through steady GDP growth, low unemployment, and a resilient consumer. Policymakers continued to navigate these dynamics, emphasizing the importance of managing potential challenges while fostering economic growth and stability.
Rising bond yields took center stage in the third quarter, driving market dynamics. High treasury yields triggered performance shifts across various sectors and indices when compared to the preceding two quarters.
Regarding market capitalization, large-cap stocks once again outperformed their smaller counterparts, just as they did in the first two quarters of 2023. However, both large and small caps saw negative returns. This outperformance by large caps aligns with the trend of increasing treasury yields. Smaller companies, reliant on debt financing for their operations, face stronger financial headwinds as interest rates rise, making it more challenging for them compared to their larger peers.
In terms of investment styles, there was a reversal in performance compared to the first two quarters of the year. Value stocks relatively outperformed growth stocks in the third quarter, although both categories ended with negative quarterly returns.
At the sector level, nine out of the 11 S&P 500 sectors recorded negative returns in the third quarter, a stark departure from the broad gains seen in the second quarter. Energy emerged as the top-performing S&P 500 sector during this period, driven by a surge in oil prices. The Communications Services sector also posted a modest positive quarterly return, as there were expectations that the integration of advanced artificial intelligence would boost future advertising revenues for search and social media companies.
However, the influence of rising bond yields was evident among the sector laggards. Consumer Staples, Utilities, and Real Estate sectors were the worst performers in the third quarter.
On the global stage, international markets experienced modest declines once more, falling behind the S&P 500 during the third quarter. This lag was fueled by underwhelming economic indicators in Europe and China, which heightened concerns of a regional recession. Notably, emerging markets displayed relatively better performance compared to their developed counterparts, mainly due to the late-quarter announcement of a substantial economic stimulus package in China.
The prominent benchmark for bonds, the Bloomberg Barclays US Aggregate Bond Index, experienced a moderate decline for the second consecutive quarter. This decline was attributed to the Federal Reserve's hawkish rhetoric and indications of a potential resurgence in inflation, which had a broad impact on fixed income markets. U.S. treasury bonds contributed the most to the bond market’s decline for the quarter. On September 27, the 10-year note reached its highest point since 2007 at 4.61%. Closing out the third quarter, the 10-year treasury note settled at 4.59%, the 20-year treasury at 4.92%, and the 30-year note at 4.73% (Source: treasury.gov). This movement exemplified the rule of the bond market that as yields rise prices decline.
In the corporate bond market, lower-quality, higher-yielding "junk" bonds saw a slight increase in value, while higher-rated, investment-grade debt experienced a moderate decline in the third quarter. This notable performance gap reflected investors' persistent optimism regarding future economic growth. Investors reached for the higher yields offered by riskier companies amid the backdrop of steadily rising bond yields.
Keep in mind that should the Federal Reserve opt to relax or reverse interest rates, the window of opportunity for locking in lower-risk, higher-yielding bonds & CDs may narrow. Currently, the Federal Reserve has indicated the possibility of one more interest rate hike, preserving the potential for higher short-term rates.
We will continue to closely monitor the impact of both the Federal Reserve's actions and the rising interest rates on bond yields.
Entering the fourth quarter, investors must brace themselves for potential volatility on the horizon. The optimism surrounding imminent interest rate reductions waned during the third quarter, as the possibility of a rate hike before year-end made headlines. While most experts believe the interest rate hike cycle is peaking, the prevailing sentiment now seems to be "higher for longer."
Historically, the fourth quarter has been a robust period for U.S. stock markets, with a track record of positive returns since 1928, even in the face of challenging Octobers, like the infamous one in 1987. However, the current year presents several factors that could influence market dynamics. The surge in oil prices and lingering monetary policy ambiguity, combined with a fiercely contested White House race, are raising concerns.
In light of these uncertainties, it's crucial to be proactive in preparing your personal financial plan to weather potential economic storms. Building financial liquidity, steering clear of excessive debt, and carefully considering major financial commitments like weddings or new car purchases are prudent steps. Recent years have taught investors the wisdom of expecting the unexpected.
We maintain our belief in the long-term commitment to equities. While volatility persists, caution is advisable in the months ahead. Market challenges may arise, making long-term stability a paramount goal for savvy investors. Remember, history has shown that staying diversified and committed to a well-devised, long-term financial plan is a rewarding strategy.