Quarterly Newsletter for 2023’s 3rd Quarter
After three consecutive quarters of positive returns, stocks pulled back in the third quarter with the S&P 500 Index declining 3.3%. Other asset classes, such as small/mid-cap stocks and international equities posted slightly larger declines. Attributing the quarterly pullback to poor economic data or disappointing corporate earnings results would be difficult. Recent economic data points and earnings releases have generally been strong and better than expected. The weakness in risk assets was a result of the sharp and rapid spike in interest rates that occurred in the quarter.
Increase in 10-Year U.S. Treasury Bond Yields in the Third Quarter
With bond yields rising to the highest levels in more than 15 years, fixed income allocations provided no ballast to portfolio returns. Intermediate and long-maturity bond indices posted declines similar to equity markets, erasing positive year-to-date returns. However, on the positive side, the significantly higher bond yields currently being locked in when new bonds are purchased in portfolios should help buffer bond price volatility going forward.
We can attribute the spike in interest rates/bond yields to a wide range of issues and developments that warrant monitoring. An abbreviated list includes the following:
- Economic growth has remained solid. In fact, the Federal Reserve Bank of Atlanta estimates a third-quarter GDP growth rate of close to 5%.
- Oil prices increased by almost 30% in the quarter, which had an observable impact on headline inflation.
- While the Federal Reserve decided to leave interest rates unchanged at their September meeting, they stressed their “higher for longer” mantra, increased their economic growth forecast, and are now projecting fewer interest rate cuts in 2024 compared to their view in June.
- In early August, Fitch Ratings downgraded U.S. Treasuries from AAA to AA+ due to a growing debt burden and political dysfunction in Washington.
- The Treasury Department released borrowing estimates for the second half of the year, which were significantly higher than expectations. The Treasury plans to borrow a staggering $1 trillion in the third quarter and another $852 billion in the fourth quarter. Unsurprisingly, the massive increase in supply has translated into lower bond prices and higher bond yields.
In the near term, we expect the path of interest rates to dictate the direction of financial markets. It will be challenging for equity markets to advance without stabilization in the bond market. We do see several developments that have the potential to lower interest rates. Economic momentum is likely to slow after a surprisingly strong third quarter as tighter monetary and credit conditions weigh on economic growth. Consumers have nearly depleted excess savings that have supported elevated spending levels. The timing of this development corresponds with a tick-up in delinquencies on auto loans and credit card debt. Outside of the spike in oil prices, there have been some positive developments on the inflation front. Wage growth has cooled and the most recent core inflation reading came in at 2.2% using a three-month annualized rate. While these data points may not align with expectations for a rip-roaring economy, that’s not the outcome investors want to see. We’re in a “bad news is good news” environment where investors want to see evidence of a cooling economy that brings down inflation and interest rates.
While several of the factors contributing to the recent spike in interest rates could reverse course, we acknowledge that the supply-demand picture for bonds is not encouraging at present. U.S. debt levels stand at $33 trillion, and Washington is running large budget deficits in a period of full employment. With no signs of fiscal restraint in D.C. and the Federal Reserve reversing course after a long stretch of supporting demand for government bonds through their Quantitative Easing programs, these supply-demand dynamics aren’t likely to improve any time soon. Policymakers need to come to terms with the fact that borrowing money is no longer free, and as such, the basic rules of economics apply to them as well. When supply overwhelms demand, the result is lower prices or, in this case, higher borrowing costs.
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