Resilience in the economy turned into a headwind for bonds, then stocks.
Despite the many calls for recession, the US economy has remained resilient so far this year. Real GDP increased at an annual rate of 2.1% in the second quarter of 2023 with the primary contributors being consumer spending and business investment.
According to the most recent Federal Reserve Bank of Philadelphia survey of professional forecasters, expectations for GDP have been revised higher and growth for 2023 is expected to be 2.1% year over year, with expectations of 1.3% for 2024. This is slow by historical standards, but a far cry from the expected contraction.
While economic strength on the surface is good news, in the short-term, resilience in the economic data has posed as a headwind for Treasury bonds, swaying expectations around the Fed’s outlook. Data supporting a stronger economy means the Fed will likely keep interest rates higher for longer.
In the Treasury bond market, the 10-year Treasury yields rose to levels not seen since 2007 on heightened Fed concerns. Higher yields challenge equity valuations, and stocks ended lower for Q3 as well.
Consumer Price Index (CPI) inflation has come down from a peak of 8.9% year-over-year last June to under 4% in September 2023. Energy prices are lower than they were in 2022 but have been steadily climbing as of late, due mainly to OPEC production cuts. Improved supply chains and declining demand has allowed inflation to ease across core goods categories.
Shelter inflation is also declining; however, inflation in core services continues to trouble the Fed. Powell frequently cites it when speaking about persistent inflation pressures.
The Fed and the Yield Curve
Since the beginning of 2022, the Fed has hiked rates on the short end of the yield curve by a cumulative 5.5 percentage points to slow high inflation.
The Fed paused on rate hikes at its most recent meeting September 19–20, 2023, and market pricing reflects some expectation they could be done. Powell has indicated a willingness to be patient from here. “We have to be ready to follow the data, and given how far we’ve come, we can afford to be a little patient, as well as resolute,” Powell said
According to the dot plot provided after the Fed’s meeting September 19–20, the median Federal Open Market Committee (FOMC) member expects a year-end federal funds rate of 5.6%, implying the possibility of one more rate hike this year.
The committee also increased the forecast for rates in 2024 and 2025, reflecting its concern that elevated inflation may warrant restrictive monetary policy for longer.
This higher-for-longer mantra from the Fed coupled with resilience in the economic data has caused longer-dated treasuries to sell off in price and move higher in yield.
Another factor pushing yields higher has been a surge in supply. The Treasury's needs have been rising partly because of growing deficits and partly because the Treasury had depleted its cash reserves held at the Fed before the debt limit was lifted by Congress in early June.
Yields on the benchmark 10-year Treasury reached 4.7% during the quarter, the highest level since 2007. The average mortgage rate rose above 7%, its highest level in more than 20 years.
The labor market has been a bright spot this year, tracking a near-historic low unemployment rate of 3.8%. Recent employment reports have shown the economy continues to add jobs, though the trend of job gains is slowing.
Slowing job creation and a lower quits rate by workers may mitigate wage inflation going forward. In our view, a severe recession is hard to imagine unless the employment picture were to dramatically decline. This supports a softer landing scenario for the US economy.
Through May, a handful of the very largest tech stocks were driving the vast majority of the US market’s upside returns. In August and September, these same mega cap names came under pressure as longer-term interest rates rose. Higher interest rates weigh on the valuations of long duration assets like technology. The US market index ended the quarter down 3.3%, 7.9% off the high reached on July 31.
During the quarter, the US equity market as measured by the S&P 500 outpaced the MSCI EAFE Index by a slight margin, however emerging markets outperformed.
We view Q3 weakness in equities as nothing out of the ordinary given historical seasonality trends suggest August and September tend to be tough months. Overall, stocks have had a good start to the year with the Russell 3000 up approximately 13% year to date. The average annual return for the Russell 3000 has been 9.53% over the last 20 years. Seasonality is based on observations 2003–2022.
It’s impossible to predict what will happen to markets in the short term, but markets have historically done relatively well following a peak in inflation, the conclusion of a Fed tightening cycle, and a trough in consumer confidence. The stock market often bottoms before the economy, which is why it’s important to not try to time the markets but to stick to the long-term plan.
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