Commentary - Q3 2023
In the third quarter of 2023 the stock market’s performance reflected concerns about inflation, rising interest rates, and the effects of current economic policies. The broad market, as represented by the S&P 500 Index declined 3.3%. Negative returns were spread across the size spectrum. The S&P MidCap Index returned -4.2% and the S&P SmallCap Index returned -4.9%. On a year-to-date basis the broad market generated a 13.1% return, the MidCap Index returned 4.3% and the Small Cap Index rose 0.8%. S&P
Both growth stocks and value stocks declined during the quarter. The S&P 500 Growth Index fell 2.6% and the S&P 500 Value Index declined 4.1%. For the first three quarters of 2023, Growth stocks returned 18.1% and Value stocks returned 7.6%.
Bond returns were negative as well during the quarter and on a year-to-date basis. The Bloomberg Aggregate US Bond Index fell 3.2% in the recent quarter and returned -1.2% for the last three quarters. Bonds with longer maturities declined substantially as interest rates rose. The Bloomberg US Aggregate Government-Treasury Long Index fell 11.8% in the quarter and 8.6% in the first three quarters of the year. The short end of the yield curve provided positive returns in the third quarter. The Bloomberg US Treasury Bills Index (1-3 months) rose 1.3%.
In summary, in the third quarter both stocks and bonds generated negative returns, growth stocks fell less than value stocks, bond returns were negative, and cash-like debt instruments performed better than either stocks or bonds. On a year-to-date basis, the stock market has risen, but the bond market has experienced negative returns.
The Fed has been raising the Fed Funds rate to reduce the rate of inflation. While the Fed manages rates at the short end of the yield curve, the market determines the level of longer dated fixed income instruments. A change in the shape and location of the yield curve reflects a change in expectations.
In his 1896 paper, “Appreciation and Interest”, Irving Fisher proposed a relationship between nominal interest rates, inflation, and real interest rates. His insight was that real interest rates are the difference between nominal interest rates and inflation. As investors look forward, they have expectations with respect to both inflation and real interest rates. As these expectations change, nominal interest rates change.
Currently shorter-term obligations offer higher yield than do longer-term obligations. The curve is inverted and has been for some time. Treasury bills yield about 5.4% currently and 10-year government bonds yield about 4.8%. The shape of the curve is consistent with expectations that the combination of inflation plus real economic growth (a determinant of real interest rates) will decline over time, however rates have risen along the curve. While the curve has remained inverted, the new location of the curve suggests that expectations for the level of the sum of inflation and real growth have increased.
Expectations for the behavior of prices and real output over time are informed by near term changes in economic conditions and policies. Currently, the Fed and the Treasury are pursuing policies that are not working towards the same objectives. By raising interest rates the Fed is trying to reduce liquidity and thereby lower inflation. At the same time, the Treasury is planning to enact budgets with large deficits. The CBO estimates of the deficits arising from the Treasury’s proposed budgets will run $1.5 trillion per year for the next ten years. The Treasury will be coming to the market to make large borrowings as the Fed is reducing liquidity, if each entity follows through with its current policies.
The Fed may decide to not reduce inflation to the announced target of 2% at an annual rate and move to help the Treasury meet its need for funds. Inflation has fallen from about 9% at an annual rate in June of 2022 to roughly 3.5% recently. The money supply was declining from a peak in December of 2021 until March of 2023 at which time it stopped declining. The Fed may have undertaken an unannounced pause in its attempt to reduce both liquidity and inflation further. If the Fed changes course to accommodate the Treasury, the likelihood of rising inflation increases.
Investors in the stock market are trying to anticipate changes in the Fed’s policies as are bond market participants. The Fed’s policies directed at reducing inflation assume that lowering economic activity will reduce inflation. This assumption has its foundation in the Phillips Curve, a model of the relationship between employment and inflation. The model posits that there is a positive relationship between the level of employment and inflation, as employment increases inflation will increase, all other things being equal. While forecasts based on this model have been wildly inaccurate for almost sixty years, the Fed has clung to the model as it develops policies. In short, the Fed believes the best way to lower inflation is to reduce the rate of job creation and lower employment, throwing people out of work. Reducing the rate of job growth and economic activity reduces the rate of growth of profits, and the value of stocks.
Given the Fed’s bad news is good news approach to monetary policy, market participants have developed a fixation on job market conditions. The current consensus is that as long as job markets are tight, the Fed will remain hawkish on inflation. The job market, as represented by the unemployment rate, does appear to be near the point of full employment. However, appearances are sometimes deceiving.
The growth in employment since just before the “shut down” in response to the COVID-19 pandemic has been about 3%, or less than a 1% rate of growth per year, hardly robust. Over the same period, the labor force participation rate fell from 63.3% to 62.8%. If the participation rate had remained constant, unemployment would be more than 4.0% currently. The labor markets may not be as tight as the headlines suggest.
In addition, some major sectors of the economy are either experiencing a decline in activity or a flattening of demand. Housing starts and new home sales are declining on a year-over-year (y-o-y) basis. Retail sales in nominal dollars are up y-o-y, but when adjusted for inflation, retail sales have declined. In the first two quarters of 2023 corporate profits declined using y-o-y comparisons. The outlook for the growth of profits is clouded by uncertainty arising from the Fed’s wide choice of policy options. The consensus forecast calls for as much as a 10% increase in profits in both 2024 and 2025. Increases at these levels or above might be needed to sustain current price earnings ratios. The S&P 500 is trading at about 24.5 times trailing twelve months earning, well above the historical median of 17.9 times.
If the Fed is looking for reasons to refrain from raising the Fed Funds rate further, they are not hard to find. Should the Fed persist in raising short-term rates, economic growth will be hard to achieve, the forecasts for corporate profits will be revised downward, and interest rates at the long end of the maturity spectrum will rise as Treasury borrowings grow. An environment that includes further increases in interest rates is not likely to include rising stock prices.
In addition to the Fed’s policies, there is one more policy choice that would threaten valuations in both the stock market and the bond market. The Treasury’s budget deficits could produce an effort to increase tax rates. An increase in rates might not produce an increase in tax receipts if higher interest rates and higher tax rates produce a decline in economic activity, a perfect storm’ not unlike the late 1970’s, a period in which the economic environment included double digit inflation, double digit unemployment, and 20% short-term interest rates.
In 2023 the stock market’s advance has been on the backs of very few stocks. A comparison of the returns of the capitalization weighted S&P 500 Index (13.1%) and the unweighted Index (1.8%) is evidence of the narrow basis for the rise in the Index. This circumstance and the high valuations assigned to stocks at this time leaves the stock market highly vulnerable to the consequences of unfortunate policy choices.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.