Quarterly Market Commentary – 2023 Q3

Oct 17, 2023 | Individuals, Institutions, Plan Sponsors, Quarterly Commentary

Executive Summary

The first half of the year was full of hope that inflation will continue to decelerate and thus the Fed will take its foot off the rate hiking gas. The scenario of a soft landing fast became the (desired) base case. This is the immaculate disinflation scenario where the Fed would engineer an environment of continuous disinflation towards 2% while the economy continues to expand slowly (no recession) without a serious hike in unemployment. Although U.S. equities, on an index level, seem to be buoyant, the underlying support has been concentrated in a handful of large-cap technology/AI/communication stocks. There were periodic appearances of market participation being broadened to small and mid-cap stocks.
The third quarter witnessed a less confident scenario where we saw signs of a slowing economy, although employment remained tight and the Fed continued to push its consistent narrative of more work is needed to bring core inflation to the 2% target. Further, the Fed reiterated the need to hold rates higher for longer (not defined). We saw energy prices jump and market participants expecting the oil price to reach $100 per barrel and beyond. Consumers are still spending and traveling even though Covid-era savings continue to dwindle and now with credit card debt rising along with the default rate. At the same time, the savings rate is rising, suggesting some consumers are bracing for more economic uncertainties.
After the 2022 losses in equities and bonds, many had hoped or expected the traditional stock/bond correlation would return (i.e., less correlated). On the surface, that has been true with stocks advancing and bonds continuing to be challenged. However, the positive performance of stocks has been narrowly concentrated in a small handful of technology/AI related issues and the broader market has mostly not participated. If this handful of issues are removed from the various indexes, the stock market and the bond market have again been significantly correlated with no diversification benefits. The one bright spot has been cash (short term fixed income).
Last winter was a milder one, and Europe skated through what could have been a much harsher energy crisis because of sanctions on Russian energy supply. On February 24, 2022, Russia launched its special operation in Ukraine and the conflict continues today with no end in sight. For as long as U.S. led allies continue to support Ukraine with contributions and weapons, the conflict/war will continue. If the 2023-2024 winter in Europe turns out to be much harsher than expected, the European economy would be seriously impacted, and recession would become more of a certainty. There are increasing voices within the alliance of lowering the financial and military support to Ukraine, but even if the war stops, it is not likely that the sanctions against Russia will cease.
The terrorist attack on October 7th by the Palestinian militant group, Hamas, took everyone by surprise and led to an immediate declaration of war from Israel. It is not clear yet if Iran, the long-time benefactor of Hamas, had a direct role in planning and aiding the attack. If so, this somewhat contained conflict will spread out quickly and affect not only the Middle East (Iran, Lebanon, Syria, Saudi Arabia, Egypt, Jordan, etc.) but the price of oil (potentially stricter sanctions on Iranian oil export of which China is currently a large buyer) could spike with a military confrontation to ensue. An expanding conflict will lead to unintended and not easily containable consequences.
There is always the tension between the U.S. led West and China. The elections in the U.S and Taiwan in 2024 may add additional stress to an already tense relationship. Crossing the Red Line is no longer make believe. Even though no country (at least publicly) wants a hot war in the South China Sea, accidents can and do happen and cooler heads may not prevail.
Since the Taliban seized power in Afghanistan in August 2021, it had given shelter to some and pushed out other terrorists and extremists near the border with Pakistan. Since then, we have witnessed increasing terrorist violence in Pakistan including a recent serious attack on Pakistan’s largest city, Karachi. This is destabilizing an area with the highest number of terrorist groups. The different extremist-fundamentalist groups are also fighting each other. This is like a pot of soup getting warmer which could come to a boil one day (egged on by Hamas-Israel) and is not likely to be contained
For the U.S., our treasury and government securities, the U.S. Dollar, and gold are deemed “safe haven” assets, and these events tend to attract overseas buyers into U.S. treasuries which would push down U.S. interest rates in the near term.
Risk for the stock market – with U.S. treasuries yielding higher than the average dividend rate for stock, this means stocks must work much harder to keep their current or escalating prices. As the Fed is likely to move to 5.5%-5.7% rate, it gets increasingly challenging for stocks to continue upward. In the short term, we exact a pull back. For long term investors, this is the volatility we all love to hate in order to get us the long-term superior returns.
Risk for the bond market – if interest rates (short-end controlled by the Fed and long-end controlled by the market) continue to rise, this is bad for every kind of bond and especially the high yield (junk) bonds as they are currently priced for a soft landing. However, for long-term investors looking to lock in (through dollar cost averaging), escalating long-term yields can make sense. At worst, they can hold the individual bonds until maturity.
Great for cash – investors can easily earn 5%+ in T-Bills, CDs, and money market investments at very little to no risk to principal. Of course, the push back for leaving too much in cash is reinvestment risk (meaning the high rates will not last forever) and opportunity cost (meaning if one is not in the stock market it could turn on a dime and run away from us all). But under the current situation of high uncertainty about policies, politics, and foreign conflicts, for many investors, protecting on the downside while earning 5% or more is an attractive and prudent approach.
This is a time to review one’s investment policy (allocation to stock, bonds, cash, real estate, private vs public securities, commodities, infrastructure, gold/precious metals, etc. exposures) along with one’s cash/liquidity needs and capacity to take on risk. Each person or institution (which is made up of persons) is different, and there is no one right allocation or approach for all. An alignment of investment objectives and expectations with the portfolio is always the right way forward.