What’s Up With Financial Markets?

Oct 2023

It looks like financial markets came back from summer vacation not feeling refreshed and happy.  August and September lived up to their reputations as some of the most volatile months of the year, as the major stock market averages were down 2 to 6% each month.  As I write this, October is attempting to buck the trend and is up around 1% thus far.

The news is not all negative since the Dow Jones Industrial Average (up 3%), S&P 500 (up 15%), and NASDAQ (up 29%) indices have held on to gains this year despite negative market sentiment.  However, all three indices had been up higher before August.  The bond market, which had been positive for most of the year, turned negative over the past month as long-term interest rose significantly, down about 2%, as represented by the Bloomberg U.S. Aggregate Bond Index.

Interestingly, the September jobs report, which showed a gain of 336,000 new jobs with 4% wage gains year over year, only adds to the uncertainty of further rate hikes by the Federal Reserve.  Good news on the economic front doesn’t always translate to good news for financial markets.  The longer the Fed keeps interest rates high or higher, the more pressure it applies to stocks and bonds.

Despite the negative sentiment grabbing hold of investors’ psyche, there are some silver linings:

Inflation is declining.  Inflation has decreased meaningfully (CPI currently at 3.7%) from its June 2022 high of 9.1%, partly thanks to the Federal Reserve’s rapid rate hikes.  However, CPI has risen for three consecutive months ending September, mainly on higher energy (oil) prices, although many economists believe the trend won’t persist.  At this point, it is clear the rate-hike regime is closer to ending than continuing.  While the Fed continues to be concerned about inflation, there are signs that the effects of Fed policy are working their way through the system.

I believe the Fed has the upper hand on inflation.  However, their job won’t be finished until inflation moves closer to their 2% target.

If the Fed decides to hike rates again, I believe the rise in long-term interest rates we’ve seen since August will ultimately help the Fed fight to slow economic activity. Policymakers see rising yields as a way to slow the economy without going through the trouble of raising rates again.  In effect, elevated yields can do the work of the Fed — functioning as a rate hike without instituting an actual rate hike.  This theory will be tested at its November 1st meeting.

Bond yields are attractive again.  Yes, bonds are down again this year, albeit not as much as last year.  Bonds are currently in a three-year bear market, the longest in history.  Remember, as interest rates rise, bond values decline.  That’s the bad news.  The good news is that current yields on high-quality bonds are 5 to 5.5%, which investors haven’t seen in at least fifteen years.

If interest rates decline, the higher interest income and possible price appreciation (bond values rise as interest rates fall) make bonds more attractive to own than CDs, T-Bills, and high-yielding money market funds long term.  The key here is “long-term.” If short-term interest rates decline because of a shift in Fed rate policy (they lower the Fed Funds rate to help stimulate the economy), bond yields will look more attractive than cash as yields fall.

Despite higher short-term rates, we maintain some exposure to longer term core/high quality bonds in our portfolios.  The Bloomberg U.S. Aggregate Bond Index yields 5.4%, above the current 3.7% inflation rate.  So, bonds are finally providing a positive real (after-inflation) yield.  Bonds play an integral role in our more balanced portfolios, as we believe they will likely provide some downside protection during a recession or prolonged stock market decline.

Resilient stock market.  Most major stock market indices have been under recent pressure because they fear the Fed may keep short-term interest rates higher for longer than predicted.  The thought here is that higher yields on safe instruments like CDs and cash compete with returns on stocks, so the longer cash yields stay with us, investors may be tempted to sell stocks and move to cash.  In the long run, cash has dramatically underperformed stocks and bonds.

The stock market also averages several pullbacks and corrections throughout the typical year.  And not all corrections lead to negative years.  Recession fears and inflation have historically resulted in volatile markets.  More simply, what’s happening in markets now should not surprise investors.

Stock Market Pullbacks

We are also entering historically one of the best-performing quarters of the year for stocks.  For example, according to historical data from the MSCI All Country World Index, which accounts for 99% of the world stock market, the last ten weeks of the year contributes to 67% of global equity returns during this period. There are no guarantees we experience a similar outcome, but extreme negativity can often signal a reversal to positive gains.

Closing Thoughts

As we look ahead, if a recession is in the cards, we think it will be mild, mainly because people have been expecting one for over a year.  Of course, the timing and magnitude of the Fed’s response to economic data will be critical to the outcome.  Currently, the Fed is signaling 0.50% rate cuts in 2024, but they may cut more meaningfully or not at all, depending on data.  Therefore, we can’t rule out the possibility that the Fed does thread the economic needle and successfully guides us to the rare soft landing.  In this scenario, we think stocks and bonds may perform well.

Given the uncertainty, we expect continued volatility.  We think it will be more critical than ever to keep our pencils sharp and be ready to take advantage of market dislocations through our portfolio rebalancing effort.  We believe taking a disciplined long-term view is the path to successful investing.  We will maintain a balance of offense and defense, seeking attractive risk-reward opportunities that are supported by thorough analysis.

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