Jayson Moss, CFA
Chief Investment Officer
Despite advancing in July as investors adjusted their expectations towards a “soft-landing” scenario, U.S. equity markets declined in the third quarter of 2023 as worries continued to build throughout the quarter that interest rates would stay higher for longer. All told, the Nasdaq Composite Index decreased 4.1%, followed by the S&P 500, which declined 3.3%, and the Dow Jones Industrial Average down 2.1% for Q3 2023. Fixed income indices were also broadly lower in the third quarter, noting the Bloomberg U.S. Intermediate Aggregate Bond Index decreased 1.9% in Q3 2023 as rates along the yield curve increased. It is worth pointing out that the yield on the 10-year U.S. Treasury note breached 4.6%, its highest level since 2007.
Inflation, which has remained stubbornly high, has started to cool. In August, it was 3.5% higher year over year, compared to 3.4% in July and 3.2% in June. The core price inflation rate, a closely followed inflation measure used by the Fed that excludes food and energy prices, has also pulled back from its high in early 2022 to 2.2% over the last three months ending August 2023. This is very much in line with the Federal Reserve’s 2% benchmark target. However, to keep inflation and employment in check, Fed officials signaled during their last meeting in September that rates would stay higher for longer, implying that the neutral rate which remained low since the financial crisis has risen. Resetting rate expectations resulted in higher near- and longer-term rates a change which, in turn, has placed pressure on fixed income and equity prices.
Source: Commerce Department
Higher rates have implications on the broader economy, for consumers and businesses large and small. While the economy has been resilient, cracks are showing. Consumers that need to borrow money for large ticket items, such as cars or houses, are finding higher borrowing costs, leading to trade offs for essential and discretionary items. Mortgage rates are up over 100% compared to two years ago, currently sitting at 7%. Additionally, borrowing in the form of credit cards and other loans have impacted spending habits, given that these rates are typically tied to broader benchmarks. The higher costs further limit the ability of consumers to spend due to higher servicing costs. Overall, these higher costs are starting to change consumer spending habits. Darden Restaurants, the parent company of Olive Garden and Ruth’s Chris Steak House, recently indicated that consumers who earn at least $125,000 or more dined out less often, and, even at their casual dining chains, patrons ordered fewer alcoholic drinks and chose cheaper entrees. While these are only a few examples, they reveal that higher rates are impacting spending habits everywhere. Many corporate entities are also experiencing the same problems. Management teams that borrowed at cheap rates following the financial crisis are now facing refinancing rates that are substantially higher. These higher interest payments, in turn, limit companies’ abilities to allocate incremental capital to growth initiatives versus paying down debt accumulated in previous years.
More recently, higher energy prices, particularly the price of oil, has given us increased consternation. Notably, the price of oil increased almost 30% over the quarter, standing at over $90 per barrel on September 30. While energy prices are volatile and the recent run-up in prices has been caused by Russian and Saudi Arabian production cuts rather than by increased demand driven, sustained high energy prices can have implications on inflation and, over time, on demand. In addition, energy costs—high or low—have trickle-down effects on businesses, reverberating through the entire supply chain: from production, to ancillary input costs, to shipping, and eventually to end-market demand. As a result, we believe that sustained high energy costs increase the probability for a more meaningful or sustained economic contraction.
Despite other factors, the actions taken by central banks globally will ultimately continue to temper consumption. We continue to believe that there is a very high probability of a recession in the near term; however, the ultimate timing and magnitude of such a development are impossible to determine with certainty. Notwithstanding the current uncertain economic environment, we remain bullish on the U.S. economy in the longer term. We continue to believe that equities offer upside potential, that fixed income has become more attractive (given the prevailing interest-rate environment), and that cash has also become a more attractive asset class (given that the yields on U.S. treasury bills are the most attractive in decades).
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