“As is often the case, we are navigating by the stars under cloudy skies.” - Federal Reserve Chairman Jerome Powell
Not often is it the case that so many macroeconomic events and other political factors compete for our attention in the same quarter as they have in the past few months. In headlines – financial and otherwise – it’s not uncommon to see the implications of these recent events in markets. Given that some events affect markets more than others, our focus remains on determining which of these economic events will influence the long-term trajectory to growth - versus small bouts of market variance – in this commentary.
The topic at the forefront of many MBI clients’ and colleagues’ minds is a potential government shutdown. As of the date of publication, the can has effectively been kicked down the road for 45 days after Congress passed a funding plan. Since that time, the Speaker of the House has been removed and has yet to be replaced.
Despite concerns, in the event of a shutdown, these events do not necessarily equate to poor performance, as seen in the chart above. As a matter of fact, the longest shutdown that started in 2018 saw the S&P 500 rise almost 8%. Most interesting is that for many shutdowns, the market has the tendency to decline before the actual shutdown, and according to the RBC Capital Market Strategist Lori Calvasina, the S&P 500’s median drop during actual shutdowns was 2%.
While we expect that complications arising from a government shutdown remain limited, we do expect the impact of inflation to continue. The Federal Reserve’s dual mandate of price stability and maximum employment through monetary policy is no mean feat. Often, the actions taken, whether through changes in the Fed Funds rate or through quantitative tightening or easing, have opposing effects on these two goals. What causes inflation to decrease often causes unemployment to increase and vice versa. Today’s economic environment is challenging as the Fed seeks to suppress inflationary forces — or in the words of Chairman Powell, “achieve price stability” — while limiting rising unemployment. Thus far, the results have been muted. Inflation has come down, albeit not as much as necessary, while unemployment continues to be near all-time lows. If you have read a financial publication lately or tuned into a financial news channel, you may have seen reference to the notion that interest rates are going to remain higher for longer. What is the rationale behind this expectation and what are its implications? First, we need to think about the primary motivator behind the Federal Reserve’s push for a higher Fed Funds rate: inflation.
In the chart below, core inflation (inflation minus food and energy) spiked in September 2022 at 6.6%, which is a multi-decade high. The Fed’s response was to increase rates quickly to 5.5%. Inflation has come down from last year’s high.
Some disinflationary forces, such as resolution of supply chain disruptions and completion of fiscal policy stimulus, helped to lower that Core CPI figure to 4.3% today. However, the Fed is still quite far away from its own stated target of 2% long-run inflation. One apt analogy is freight delivery. Shipping from Point A to Point B is at its least complicated when it involves sending freight from one hub to another. However, it is that final mile to the destination that is more complex and costly. From the Fed’s point of view, getting inflation at or near 2% is the goal, or in the words of Fed Chairman Jerome Powell, “restoring price stability.”
Second, adding to the inflation control challenge is the U.S. economy’s better-than-expected performance. Last year, the market expected the economy to fall into recession as the Fed Funds rate sharply increased. That simply has not happened. As a matter of fact, most of the economic releases have been better than expected. Actually, this improved performance contributes to keeping inflation higher than the Fed would like. The Fed then has a choice: 1) continue to increase the Fed funds rate, or 2) commit to keeping the rate higher for a longer time. Although Powell has given the impression that the Fed may still increase rates, the stronger signal has been that most of the rate increases are now done, but that any rate cuts may take longer depending on how inflation readings respond. Thus, the market is faced with the prospect of interest rates higher for longer.
There are other potential complications to add to the Fed’s calculus, such as the United Auto Workers (UAW) strike and the increase in oil prices. In the case of the strike, the increase in wages via a negotiated strike settlement would be inflationary, thus creating further challenges to current monetary policy in its fight to reduce inflation. In the case of oil, OPEC’s reduction in oil production is having the cartel’s desired effect of increasing oil prices. Additionally, the recent conflict in Israel already has oil prices climbing as well. While the Fed’s preferred measure of inflation excludes more volatile food and energy categories, the impact of higher oil prices cannot be denied for consumers and businesses. These factors would also point to the Fed needing to keep interest rates elevated to combat existing and potential sources of future inflation.
While domestic equity markets have had a solid run this year in the first six months, over the past quarter we’ve begun to see stagnation. During our last commentary the market rose 19.25% for the first six months of 2023; however, by the end of the most recent quarter the market is “only” up 12.81% for the year. The month of September was particularly challenging, with the S&P 500 falling 4.77%.
Part of the cause for the market decline could be attributed to the market’s adjustment of its future expectations for interest rates. As the US government sells more bonds at higher yields – which has been the case – equities begin to lose their allure.
The biggest distinction in-between asset class styles are recent returns between growth versus value and core. Year-to-date, growth has remained ahead, returning over 20% versus the other single digit returns. However, with these early gains came losses in the most recent quarter as well, with growth declining nearly 6% versus value returns of approximately 2%.
While rising interest rates affect the equity market as a whole, the Utilities sector in particular has had trouble maintaining upwards momentum. Utilities stocks are known for providing stable, relatively safe dividends paid periodically, not unlike fixed income similar to a bond. When interest rates increase, bond yields become more attractive to investors, who would rather hold a 1-year treasury yielding 5% versus a utility that may yield the same amount but may be riskier.
We’ve often covered the “Magnificent Seven” stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla), which have had a tremendous year thus far. It is fair to say that they have powered the broad large cap equity index returns. However, their combined market caps account for about 27% of the S&P 500 Index and 43% of the NASDAQ 100. With those levels of concentration, and given their current valuation, we believe it is important to maintain diversification within the equity allocation across other market caps and geographies, including Mid-Cap, Small-Cap and International Equity.
With regards to the fixed income market, higher rates today mean higher yields in bonds, which in turn means more productivity from the fixed income asset class. Furthermore, there is an even bigger benefit now to having diversification between equities and fixed income.
One important point we should note is that longer-term rates have been rising. The difference between the 10-year treasury rate and the two-year treasury rate has been shrinking.
In normal market environments, we expect longer-term rates to be rising. When longer-term rates are lower than shorter-term rates, the yield curve is said to be “inverted,” which is usually the case when the market expects a recession. Recall in 2022, as the Fed was raising the Fed Funds rate very aggressively, market expectations were for these increases to cause a recession in 2023. The market’s response was to price longer-term bonds in such a way that their yields were lower than short-term rates, based upon the expectation that in the future, rates would be lower than they are today. This expectation for lower future rates is very rational if a future recession occurs and the Fed starts to cut rates to spur growth. But that recession never materialized. Now, the bond market is adjusting its expectations. This has led to longer-term rates rising relative to shorter-term rates. The inversion is beginning to flatten.
As we have noted in the past, rising rates mean lower bond prices. Thus, when longer-term rates are rising, we should avoid longer-term fixed income as an investment. Currently, we prefer shorter-term maturities in fixed income.
Toward the beginning of 2023, our capital market expectations toward Large-Cap stocks were bullish given the then-current price to earnings and other valuation ratios were attractive and. Since that time, we have seen Large-Cap growth produce 27% returns versus a broader market 13% returns. While we consider this successful, since then, we’ve seen growth draw back a little bit from its YTD highs.
With regards to these large gains, taxability is always important when considering trades in’ portfolios. This means assessing whether selling funds will result in capital gains or losses, allocating funds with higher return expectations to tax-advantaged accounts, and harvesting losses in taxable accounts when possible.
As stated in the previous commentary, we continue to maintain neutral market expectations for Mid-Cap and Small-Cap Equities. Small-Cap equities in particular have underperformed in the past year, and may be reaching ultimately attractive prices.
Additionally, we recommend monitoring International Equity positions. Recent conflicts in Europe and the Middle East have drawn concern for these positions. This is in addition to economic concerns in large emerging market economy China given unemployment numbers, other numbers. Typically, these conflicts don’t necessarily have large long standing results on the market.
We have remained short duration fixed income securities given Federal Reserve expectations. Given that current strong economic situation, as well as possible resurgence in inflation, we continue to remain short duration. However, with interest rates for the 10-year and 30-year treasuries briefly breaching as high as 5%, we may consider increasing our expectations for long maturity securities. Currently, high credit ratings are more attractive than high yield counterparts, but remain less within the scope of our conviction.
Thank you and stay safe and healthy!