The strong price momentum experienced during the first half of 2023 continued into the start of the third quarter as stocks rose in July. Better-than-expected second-quarter earnings reports helped fuel the gains along with cooling inflation and a growing belief that the U.S. economy may avoid falling into a much-dreaded recession.

However, sentiments turned in August when faced with multiple headwinds. Rising bond yields, credit rating downgrades for both U.S. government debt and corporate debt, and continued economic weakness in China dampened investor enthusiasm. A late-month rally trimmed losses, but ultimately it wasn’t enough to keep August from ending in the red.

The slide continued into September. An early-month rally faded as the major automaker unions went on strike and consumer confidence dropped. Rising oil prices fueled fears that the Fed might need to again raise rates to combat inflation triggered by the higher energy prices. Investors will be looking to the earnings season in October and a November Fed meeting as key drivers in determining if Q4 can regain a grip on the market resiliency we saw during the first half of the year.

 

ECONOMIC CONDITIONS:

U.S. – Cooling Down

GDP: The final revision of second-quarter GDP reflected a 2.1 percent annualized growth rate, down from the Q1 GDP growth of 2.2 percent. [9]

Labor: Nonfarm payrolls grew by 187,000 in August, while the payroll estimates of June and July were revised downward by 110,000. Over the last three months, job gains have averaged 150,000, which is down substantially from its 238,000 monthly average gain for March through May. [10]

Housing: Housing starts slipped to 11.3 percent, touching levels not seen since the pandemic. The steep decline was the result of a large drop in new construction of multifamily homes. [13]

Existing home sales fell 0.7 percent as higher mortgage rates and low inventory continued to weigh on the markets. Sales were down by 15.3 percent from last August. [14]

New home sales slid 8.7 percent in August, although they were higher by 5.8 percent from a year ago. [15]

International: Slowing Momentum

Eurozone shares fell in Q3 amid worries over the negative effects of interest rate hikes on economic growth. However, data released at the very end of the period showed eurozone inflation slowed to a two-year low of 4.3% in September, down from 5.2% in August. This could potentially pave the way for the European Central Bank to put an end to interest rate rises.

UK equities rose over the quarter. The large UK-quoted diversified energy and basic materials groups outperformed as they rebounded from weakness in the previous quarter. They benefited from sterling weakness against a strong dollar. A sharp recovery in crude oil prices buoyed the energy groups in particular.

The Japanese equity market demonstrated resilience during the Q3 market correction triggered by rising interest rates and bond yields in the US and Japan. In Japan, large growth stocks were impacted by the correction, resulting in a decline of 4.0% for the Nikkei 225 index. However, smaller stocks held up well, and value stocks experienced a surge. As a result, the TOPIX Total Return index generated a modestly positive return of 2.5% for the period.

 

EQUITIES: Correction Ahead

U.S. EQUITIES: Stocks lost a portion of their first-half gains in the third quarter as a continued tight monetary bias from the Federal Reserve sent bond yields higher, unsettling stock investors throughout August and September. For the three months ending September 30, the Dow Jones Industrial Average declined 2.62 percent, while the Standard & Poor’s 500 Index lost 3.65 percent. The Nasdaq Composite fell 4.12 percent.1

DEVELOPED INTERNATIONAL EQUITIES: For Q3 2023, the MSCI-EAFE Index fell 4.71

percent.6 European markets were mixed, with quarterly losses in France (-3.84 percent), Germany (-4.71 percent), and Spain (-1.72 percent). The U.K. tacked on 1.02 percent and Italy was flat (+0.04%).7 Pacific Rim markets were down for the quarter, with China’s Hang Seng falling 5.85 percent and Japan’s Nikkei dropping 4.01 percent. [8]

EMERGING MARKETS: Despite a strong start, the MSCI Emerging Markets (EM) Index ended the quarter in negative territory, albeit ahead of the MSCI World. Concerns that strength in the US economy will keep interest rates higher for longer had a negative impact on risk appetite. This was combined with ongoing weakness in the Chinese economy and concerns about the property sector. The Emerging Market Index was down 1.63% on the quarter, leaving it up only 1.99% for the year.

FIXED INCOME: More Hikes Possible

U.S. FIXED INCOME: During Q3 the US economy continued to surprise in its resilience, with the labor market remaining relatively robust and the manufacturing sector showing signs of improvement. Concerns over rising US debt issuance weighed on the Treasury market. August saw Fitch Ratings downgrade the US’s triple-A rating to double-A plus, citing the growing debt burden and an “erosion of governance” as reasons for its decision. After raising interest rates unanimously by 0.25 percent following the March and May meetings of the Federal Open Market Committee (FOMC), the Fed elected to keep rates unchanged in June, pausing to assess the economic impact of the cumulative rate hikes to date. Language in the rate announcement and comments by Fed Chair Powell indicate that, despite the pause, two more rate hikes are likely before the end of the year.22 The US 10-year yield rose from 3.81% to 4.57%, with the two-year going from 4.87% to 5.05%.

DEVELOPED INTERNATIONAL FIXED INCOME: Both the US Federal Reserve (Fed) and the European Central Bank (ECB) raised rates in July by 0.25%, with the latter continuing the hike into September. The ECB suggested that this rate might be sufficient to guide inflation back to its target. Despite the Federal Reserve and the Bank of England keeping rates steady in September, the market anticipates a longer period of elevated rates. This was the key driver of higher yields (meaning lower bond prices) over the quarter.

Led by the US, global government bond yields peaked in September before slightly retreating at the quarter’s end. In Europe, Germany’s 10-year yield increased from 2.39% to 2.84%.

While the Bank of England raised the base rate to 5.25% in August, signs of slowing inflation allowed the central bank to keep rates unchanged in September. This helped gilts outperform, with the 10-year gilt remaining relatively unchanged over the quarter.

QUARTERLY FOCUS: A Primer on Private Credit

Within our Alternative asset class, private credit is one of many strategies that we use to help diversify portfolios. Private credit often refers to direct lending to small or middle-market companies that cannot or choose not to tap into public credit markets to finance their business needs. Within the asset class, investors and borrowers alike often look to this segment for consistent income, downside resilience, and portfolio diversification from core private credit and enhanced return from distressed private credit.

Utilizing private credit in a portfolio in recent years – and more specifically direct lending – has been an increasingly attractive asset class for investors looking for enhanced income, mitigated downside risk and diversification. Traditionally, direct lending has been considered to be an extension of public fixed-income investing thanks to the yield benefits it provides.

Today, investors can also look to the asset class for a buffer against inflation as most direct lending loans have floating rate coupons, therefore reducing duration risk and offering upsides during periods of rising interest rates.

Investors are expected to be particularly sensitive to the mid-October release of September inflation data. The prospect of a rate hike will potentially increase if consumer and producer prices prove higher than anticipated. On the other hand, if the report data comes in lower than expected, it may take some pressure off of the Fed.

The second-quarter earnings season, which largely ended in August, helped support stocks with better-than-expected results. As of August 25th, with 485 of the companies in the S&P 500 reporting, 79 percent posted earnings above market estimates. [2]

Perhaps more importantly, Wall Street’s outlook for third-quarter earnings improved during the quarter. Consensus analysts’ forecasts are estimating a 0.2 percent growth in earnings for the S&P 500 companies. Although this forecast appears slightly underwhelming, it would mark the first quarter of year-over-year earnings growth since the third quarter of 2022. [3]

As we highlighted earlier this year, the tighter lending standards resulting from the banking crisis in Q1 ‘23 are likely to have a significant impact on borrowers. Banks will be less willing to lend money, and those that do will likely require higher credit scores, larger down payments, and more stringent income verification. This could make it more difficult for individuals and businesses to obtain financing for homes, cars, and other purchases. Additionally, tighter lending standards may lead to a slowdown in economic growth as businesses struggle to access the capital they need to expand and create jobs.

Overall, the banking crisis and resulting tighter lending standards are likely to have a far-reaching impact on the economy and individuals’ financial well-being. As shown in the chart to the left, direct lending yields have increased as the Fed has driven rates from 0.5% to over 5.0% over the last two years. Direct lending is one of the Alternative asset classes that has benefited from the higher rate environment and tighter lending standards. Not only does it offer higher yields than other high-yield asset classes, but it can offer lower volatility as well – especially when compared to publicly-traded assets like US High Yield and Real Estate.

 

DPWM OUTLOOK: Look to Alternatives

Despite some hotter-than-expected inflation data, the Fed elected to keep interest rates unchanged following the September meeting of the Federal Open Market Committee (FOMC). With the government shutdown averted in late September, the Fed will have current data when the FOMC comes together again with a two-day meeting ending on November 1st to determine what will come next for interest rates, a decision that will most likely be data dependent. [5]

At Denver Private Wealth Management, we emphasize a prudent allocation to Alternatives within portfolios as a way to not only dampen volatility but to gain exposure to areas of the private markets that are unique from public stock and bond markets. As discussed earlier (and illustrated in the chart to the right), adding private credit to your alternative bucket can help achieve a more efficient portfolio that potentially offers less volatility and higher yields, thus a smoother ride for our clients both before and after retirement.

Overall, alternatives can be a valuable addition to a portfolio, but it’s important to understand the risks and limitations that come with these potentially higher yields. Alternatives can be illiquid, meaning they cannot be easily bought or sold, and they often have higher fees than traditional investments. As financial advisors, we carefully evaluate each of our client’s individual needs and risk tolerance before recommending any investment.

If you would like to hear more about how we are actively navigating these markets or for more perspective on the current market environment, please don’t hesitate to call our office for a review at 720.354.3850.

 

CITATIONS:
1. WSJ.com, September 30, 2023
2. LipperAlpha.Refinitiv.com, August 25, 2023
3. FactSet.com, September 15, 2023
4. SectorSPDR.com, September 30, 2023
5. FederalReserve.gov, 2023
6. MSCI.com, September 30, 2023
7. MSCI.com, September 30, 2023
8. MSCI.com, September 30, 2023
9. MarketWatch.com, September 28, 2023
10. WSJ.com, September 1, 2023
11. Finance.Yahoo.com, September 14, 2023
12. MarketWatch.com, September 15, 2023
13. Bloomberg.com, September 19, 2023
14. CNBC.com, September 21, 2023
15. Morningstar.com, September 26, 2023
16. WSJ.com, September 13, 2023
17. WSJ.com, September 27, 2023
18. WSJ.com, September 20, 2023
19. Health.gov, 2023
20. BusinessInsider.com, January 1, 2023
21. Census.gov, 2023
22. WHO.int, 2023
23. CBO.gov, 2023
24. CDC.gov, 2023