Third quarter 2023 market commentary
Chief Investment Officer Thierry Hasse
Stocks Cool After Red Hot First Half
While there are a number of positive economic trends we can point to, storm clouds have gathered over the financial markets and the summer was not kind to U.S. stocks. After delivering widespread gains in the first and second quarters, prices reversed course in Q3.
September represented the worst month of the year for the market, with the broad-market S&P 500® Index (SPY) shedding 4.9% on the month and 3.7% on the quarter (Source: Wall Street Journal). Dragging on the index were the utilities and real estate sectors — both down roughly 10% since June — and the usually-resilient consumer staples sector, which slid 6.6%.
On the other side of the ledger, energy grew 11.3% to lead all sectors in the index.
This negative environment for risk assets can be almost entirely attributed to surging long-term Treasury yields, which often serve as a bellwether for investor sentiment. For instance, 10-year Treasury yields recently reached 4.80%, which is the highest they’ve been since the Great Recession of 2007-2008. The markets are adjusting rapidly to the Fed’s new “Higher for Longer” mantra regarding interest rates, which continues to contribute to volatility.
Stock prices may continue to fluctuate in the near term, but all signs point to this environment being transitory. Economically, the future looks a lot brighter than it did a year ago.
The Latest on the Fight Against Inflation
The Fed’s aggressive stance stems from its dissatisfaction with the current level of inflation. The inflation rate (as measured by the consumer price index, or CPI) currently sits at 3.7%, and while this represents a significant drop from the 9.1% rate recorded in June of 2022, we’re still far from the central bank’s 2% target. Progress has not been linear and we saw inflation rise 0.6% in August due largely to a spike in energy prices. Consumers likely felt this most at the pump, as the price of gasoline increased by 10.6% in the span of a month (Source: U.S. Bureau of Labor Statistics).
After two-plus years of trying to curb inflation, the Fed’s cycle of interest rate hikes may finally be nearing its conclusion. But even if the process of “normalizing” monetary policy (ending the previous strategy of artificially keeping interest rates low for long periods) is complete, there are other forces at play that could explain the sharp increase in long-term Treasury yields. For instance, the US national debt now stands close to $33 trillion — yes, that’s trillion with a “T” or $1,000 billion — and rising Treasury yields could reflect an uptick in the perceived riskiness of investing in the US government. After all, if we managed our own finances in a similar fashion, we’d be in serious trouble.
Fixed Income Is More Attractive, But Not Risk-Free
In the fixed-income market, the calm that characterized most of 2023 was shattered when the prices of long-term bonds (those with maturities greater than 10 years) experienced a sharp decline. Thirty-year Treasury Bond prices fell 7.3% in September alone, serving as an important reminder that while bonds are generally less risky than stocks, they are not free of risk (Source: Bloomberg). Put simply, when interest rates rise as they have over the last two years, bonds that were issued when rates were lower become less attractive, and thus their prices fall. This is an example of interest rate risk.
To help insulate our clients from the potentially negative impact of rising rates, our fixed-income portfolios at Elevage Partners are comprised primarily of two types of investments:
- Debt instruments with short maturities, such as 6-month Treasury Bills or 1-to-3-year Treasury Notes. The duration of these securities — which measures their price sensitivity to interest rate changes — is very low and enables us to reinvest maturing securities at higher rates in the future.
- Securities with floating rates. Having a floating rate means that coupon payments adjust over the life of the investment based on prevailing interest rates, so if rates rise again in the future, these investments will earn more, too.
These investments provide clients with attractive income and capital preservation in the near term while allowing for flexibility moving forward. There will come a time when we will want to lock in rates for a longer period, but three conditions must be met first:
- Fiscal policy must normalize and the U.S. budget must be on a sustainable path.
- The cycle of quantitative tightening by the Fed needs to be near completion. After all, why should we buy below-market securities that the Fed accumulated during the Covid 19 pandemic when they are shrinking the world’s largest bond portfolio every day?
- Finally, the absolute return on 10-year Treasurys needs to be compelling. Certainly, a 4.8% yield seems very generous when compared to the 0.52% one could earn at the onset of the pandemic, but yields would need to be closer to 6% to warrant serious consideration in the context of our client portfolios.
We’re Looking After Your Financial Future
While current market volatility pales in comparison to last year’s, we’re still a ways away from the above conditions being in place. We don’t believe the time is right to take on a higher degree of investment risk. In fact, we are gradually reducing equity exposure across most of our client portfolios and increasing fixed-income allocations. The reason is simple: bonds and other fixed-income investments are now providing steady income and, in many instances, they offer a more attractive risk-adjusted return than some segments of the equity market.
At Elevage Partners, our eyes are set on your long-term goals and we believe this strategy allows us to capitalize on higher rates while taking on less risk and achieving a higher degree of diversification. Rest assured that our investment team is closely monitoring the markets every day and making adjustments to our portfolios as they become necessary. Volatility can be hard to stomach in the short term, but history tells us that each downturn in the stock market is followed by a rebound that carries prices to new highs.
Our message is to stay the course and trust your team of seasoned investment professionals to position you for the future. As always, we welcome the opportunity to answer your questions, discuss ongoing market trends, or review your investment strategy. Please do not hesitate to reach out to us if we can be of assistance.
In your service,
Thierry Hasse
Chief Investment Officer
The information contained herein represents the views of Elevage Partners at a specific point in time and is based on information believed to be reliable. No representation or warranty is made concerning the accuracy of any data compiled herein In addition, there can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Any statement non-factual in nature constitutes only current opinion which is subject to change. These materials are provided for informational purposes only and do not constitute investment advice. Any reference to a security listed herein does not constitute a recommendation to buy, sell, or hold such security. Past performance is no guarantee of future results. The historical returns of any securities and/or sectors mentioned in this commentary are not necessarily indicative of their future performance.
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