Equity Markets Under Pressure
Domestic equities declined in the third quarter of 2023, with the S&P 500 Index falling by 3.27% despite still performing well year-to-date. The main drivers of the quarter’s negative performance were rising interest rates, a strong dollar, and weakness in China, which weighed on the outlook for global growth and trade. With inflation running persistently above its 2% target, the Federal Reserve signaled that further rate hikes may be required. Energy was the best-performing sector last quarter and the only one that increased month-over-month as the sector benefited from higher oil prices. Financials also held up relatively well, with the MSCI USA Financials Index returning -0.86%. The real estate sector was hit hard, as higher rates hurt income-oriented sectors. Technology, up over 32% year-to-date, and consumer discretionary, up over 25%, continue to lead the way for the year.
International equities generally fared slightly worse than their domestic counterparts, as the MSCI EAFE Index fell by 4.04% in Q3. Excluding currency movements, Japan notably outperformed as the nation benefitted from corporate governance reforms and its post-Covid reopening. The Bank of Japan kept interest rates unchanged but signaled that it could gradually let rates rise, which would be a notable change from the decades-long situation of cheap money. China was a drag on emerging markets, as its economy continues to face issues with weak demand and high unemployment. The U.S. dollar appreciated against most major currencies, reflecting the relative strength of the U.S. economy and the expectations of tighter monetary policy.
Fixed income markets were mostly negative, as bond prices fell and yields rose in response to sticky inflation and a hawkish-sounding Fed. The rise in yields was rather sharp in the quarter, as 10-year U.S. Treasury bond yields jumped by over 0.7% and hit a 16-year high. The Bloomberg U.S. Aggregate Bond Index declined by 3.2% in Q3, and corporate bonds generally outperformed government bonds. International and emerging market debt performed worse than domestic bonds, as higher U.S. interest rates and a stronger dollar reduced the relative attractiveness of foreign bonds.
Outlook: Market Sentiment and Inflation Concerns
Moving forward, investors will be keenly observing economic indicators to gauge their influence on central bank policies and market dynamics. A large part of the weakness in the third quarter was due to investors’ fears that rates would remain higher for longer. While markets were pricing in an 87% chance of rate cuts by June 2024 in July, that probability now down to just 50%. Inflation is at the forefront of these concerns and will be pivotal in determining the Fed’s next steps.
While oil prices rose sharply in the third quarter due to OPEC’s production cuts, so-called core CPI, which excludes energy and food, increased by its slowest rate in nearly two years in August. Meanwhile, in the broader economy, there are emerging signs that the Fed’s tightening measures are achieving their desired impact. Excess savings have begun to dry up and delinquencies on credit cards, which were previously at historical lows, have reverted to pre-pandemic levels. Higher mortgage rates have slowed an otherwise hot housing market. Slowdowns in venture capital fundraising and tech startups are further evidence that the Fed’s rate hikes are having the intended cooling effect on at least some areas of the economy. Even with oil high, overall CPI is now expected to fall below 3% by the first quarter of 2024, moving the Fed closer to its 2% long-run target.
Economic Resilience and Consumer Spending
At the same time, consumer spending, a primary driver of the U.S. economy, has persisted despite some more selective behavior in specific areas. Additionally, the labor market remains extremely strong despite targeted strikes in some industries. A persistently low unemployment rate, significant job openings, and wages finally growing at a rate to keep pace with inflation all indicate that the American consumer continues to have legs. Notably, analysts are projecting corporate earnings growth of 12.2% and revenue growth of 5.6% in 2024. Quarterly GDP estimates remain positive over the next six quarters and have actually increased. Even as some of this positive economic data causes the Fed to sustain higher rates for longer, the slow but steady decline in inflation amid this generally positive economic picture gives us hope that a soft landing can still be achieved.
AI Sector Transformation and International Concerns
In the realm of technology, the AI sector has shifted from a period dominated by excessive optimism to one marked by realistic expectations. A multitude of AI companies, despite their lofty promises of high returns, have grappled with meeting the ambitious expectations set for them. This shift could be exacerbated by technical and ethical limitations, regulatory interventions, and a market gradually saturating with AI solutions. We view some cooling in this high-tech sector of the market and broadening of the market into other sectors as healthy.
On the international front, China’s economic stability raises concerns, particularly in relation to its property sector, demand, and high unemployment. Although the Chinese government has always been intent on stimulating the economy to keep up appearances during downturns, it may be increasingly challenging to counterbalance weak investments, subdued consumption, and insolvent property developers.
Adapting to Market Trends with Confidence
Over the coming quarters, we anticipate that inflation, expectations for future monetary policy direction, and those impacts on yields may continue to guide the market. Economic readings will continue to be in close focus, and the ever-important holiday shopping season is approaching. Here at Condor, we are not calling for any sort of severe recession, a view that the market more broadly appears to be coming around to. However, we are not yet out of the good-news-is-bad-news cycle, where positive data may be received less positively than one might expect (because investors expect it will keep rates higher for longer), and weaker data may actually be viewed positively (since it may lead the Fed to ease sooner). While the short-term path forward can be unpredictable in this type of environment, as always, we urge investors to take a longer view. In the meantime, we will continue to capitalize on attractive yields in safer areas of the market and would view any market pullbacks as opportunities to benefit in positions we believe in for the longer term.