Market Summary
Disinflation failed to maintain its downward trend into the third quarter after declining for the first half of the year. Domestic and international equities pared back their gains, but managed to still be up 12.42% and 5.50% respectively for the year. However, the U.S. bond market was a different story, giving up all its gains for the year and then some. The Bloomberg U.S. Aggregate Bond Index went from being positive 2.09% through the second quarter to -1.21% by the end of the third quarter, more than a 3% swing. Stocks can have these wild swings on a daily basis, but this range of movement is uncommon with fixed income and represents a significant event. As bond prices fell, their yields rose, and this is what propelled the 10-year Treasury rate to its highest levels since 2007.
| INDEX | ASSET CLASS | 2023 YTD |
|---|---|---|
| DJ U.S. TOTAL STOCK MARKET | U.S. STOCKS | 12.42% |
| MSCI AC WORLD EX-USA | INTERNATIONAL STOCKS | 5.50% |
| BLOOMBERG U.S. AGGREGATE BOND | BONDS | -1.21% |
In my last quarterly market update, I mentioned that the CBOE Volatility Index (VIX) was at a worryingly low level which might signal a level of complacency in the market. And sure enough, volatility came roaring back with a nearly 30% increase in the third quarter. This resulted in a 3.8% loss in the S&P 500 index for that same period. The drop in the broader market resulted in bringing down the forward price to earnings multiple from 19.13x on June 30th to 17.83x by September 30th. Although there was a healthy rally for most of the first half of 2023, investors just weren’t willing to continue paying more for stocks when it was nearing a 20x forward P/E multiple, given the multiple headwinds we were facing.
Inflation: The Last Mile is the Longest
After declining for twelve straight months, inflation ticked back up to 3.2% in July and 3.7% in August, but remained unchanged for September. Although these numbers are much improved from 2022, when inflation peaked at 9.1%, they’re not enough to satisfy the Federal Reserve’s mandate of 2% inflation. The Fed chose to leave rates unchanged for several months but hasn’t signaled the willingness to lower them anytime soon. We may not see lower rates for another one to two years. Federal Reserve Chairman Jerome Powell believes the U.S. economy is absorbing these higher rates well and intends to keep them at these levels for a longer period of time. Powell said, “Still, the record suggest that sustainable return to our 2 percent inflation goal is likely to require a period of below-trend growth and some further softening in labor market conditions.” The economy continues to be too resilient and the labor market is staying too tight for the Fed to warrant reversing course on its tightening policies.
Focus on Fixed Income
Although the stock market gets more media coverage, it’s the fixed income market that is larger in scale. Fixed income investments provide a less risky alternative to stocks, while providing a consistent income. Although investment grade bonds are considered lower risk investments, they are not immune to negative price fluctuations. Bond prices react inversely to interest rate changes. Starting in 1981, the U.S. fixed income market experienced a nearly four decade bull market as interest rates dropped from their sky-high levels, when the Federal Reserve was fighting double-digit inflation.
Real 10-year Treasury yields are calculated as the daily Treasury yield less year-over-year core CPI inflation for that month. For the current month, we use the prior month’s core CPI figures until the latest data is available. Data are as of September 30, 2023.
From 1981 until 2020, the Bloomberg U.S. Aggregate Bond Index went negative in only three years. However, now that we’re in a rising rate environment, we’ve seen the bond market have negative total returns for two consecutive years in 2021 and 2022. Unless there’s a rally in the U.S. fixed income market in the next two months, we may see a third consecutive year of losses. So how does a fixed income investor navigate this precarious situation? One strategy is to invest in shorter maturity bonds, which are affected less by rising rates. Money market funds have not been a viable investment option since before the 2008 financial crisis, but now offer attractive yields with ultra low risk. Diversifying your bond portfolio by geography and issuers is another way to reduce exposure in a region that’s being affected by rising rates.
Looking Forward
The broader stock market indices, like the S&P 500 Index, continue to look strong with double-digit returns year-to-date. However, the concentration of mega-cap stocks are pulling most of the weight. The S&P 500’s top ten holdings make up 30% of the index. Although the S&P 500 Index was up 13.07% year-to-date through September 30th, the S&P 500 Equal Weight Index was up only 1.79%. If the largest companies in the market, which are primarily in the technology sector, don’t continue to perform for the remainder of the year, we may see the overall markets slip into negative returns for 2023.
Tensions were already high on the global stage with the Russia-Ukraine war continuing to rage on and posturing from China. But on October 7th, the attacks on Israel by Hamas started another conflict that draws in the U.S. government. Meanwhile at home in Washington D.C., the House of Representatives was absent a speaker for three weeks. These three weeks were crucial because the United States government was running on a temporary 45-day funding bill that had averted a calamitous crisis on September 30. Congress now has until November 17th to iron out a longer term deal to avoid a shutdown.
