At the start of the third quarter, markets continued the rebound we had seen year-to- date and broadened beyond the technology sector that had been driving the market through midyear. However, as the quarter went on, the Federal Reserve indicated in several statements that rates might stay “higher for longer”. As a result, bond rates rose, pushing values down, while stocks also declined, and most portfolios gave back some of the year-to-date gains.
At the same time, investors seem to be rattled by a number of risks on the horizon that could hasten the arrival of the next recession in the economy. A possible government shutdown amid the turmoil in the House of Representatives, a broadening UAW strike, a negative impact on consumer expenditures from the resumption of student loans, and high oil prices are all combining to create concern about future growth.
Despite the dour mood, there is plenty in the markets to be optimistic about. Last year, there was broad consensus that the US would be facing a recession in 2023. Instead, we saw GDP grow 2.1% in the first quarter, 2.2% in the second quarter, and a forecasted 3% or more in the third quarter. Inflation continues to decline, the labor markets and consumer expenditures have stayed strong, and worker productivity is gaining. Business investment remains elevated. And despite credit card debt rising recently, household debt burdens remain historically low.
This is not to say the risks enumerated earlier aren’t serious, but that despite those challenges, some firewall remains between continued growth and recession. If some of the potential risks fade away – if for example oil prices decline, or the UAW strike gets resolved before it broadens to most or all UAW plants – the firewall is more likely to hold.
Stocks
The Russell 1000 index of large US companies declined -3.2% in the second quarter of 2023. Energy stocks held up well as oil prices rose. Large technology stocks notably declined, including a -12% fall in the price of Apple stock this quarter (although it is still up strongly for the year).
Smaller companies generally trailed their larger counterparts. Concern about rising rates has continued to weigh most heavily on smaller firms which in some cases will find it harder to meet the higher cost of borrowing. The Russell 2000 index gave up -5.1% for the quarter with more growth-oriented names significantly lagging the steadier, more value-oriented names.
International stock markets declined similarly, with the MSCI EAFE index of developed foreign markets posting a total return of -3.4%. It is relatively easy to see the impact of higher energy prices among country returns in this index, as the strongest performer (up 11.6% this quarter) was oil-rich Norway. Norway is the world’s third largest gas exporter and eighth largest oil exporter.
The MSCI Emerging Markets index was down -2.9% in Q3. India has been a relatively stronger performer among emerging economies this year, with a gain of 2.7% in the quarter and 8.0% year to date (compared to a loss of -1.9% for China in the quarter and -7.3% for the year).
Bonds
The Federal Reserve hiked short term rates by another ¼ percent at its July meeting, but held off on further hikes at subsequent meetings. Fed Chairman Jerome Powell has hinted that one more hike might still be coming in 2023, and the market has priced in an approximate 50/50 probability on that future rate hike. Overall, markets agree we are likely at, or nearly at, the peak for rate increases and investors expect rates to begin to decline next year (one extreme estimate, from State Street, is predicting a dramatic decline of 1-2% next year).
Long run rates have continued to rise even more rapidly, as anyone shopping for a mortgage can attest. The average mortgage rate has reached 7.3%, up from 6.7% at the end of the second quarter. Home sales have slowed considerably because most mortgage borrowers refinanced when rates were low and don’t want to give up their current mortgages to move to a new home with a new, higher rate loan.
Currencies and Commodities
The US dollar gained ground as it was seen as somewhat of a “safe haven” as global stock and bond markets fell. The US Dollar Index hit year to date highs by the end of the quarter, notably rising against the Euro and the Yen (plan your vacations now!). Crude oil prices (WTI) rose from just over $70 per barrel at the end of the second quarter to over $90 per barrel at the end of the third quarter (although they have fallen back a bit from recent highs early in October).
Looking Ahead
We are still living in a post-COVID economy. Markets had been relatively calm heading into 2020, and then the global economy suffered an enormous shock from the pandemic. Markets fell sharply, US GDP declined 32% in the second quarter of 2020, and US unemployment hit 14.7% in April that year. The economy (and stock markets) then quickly recovered throughout late 2020 and all of 2021 as stimulus was pumped into the economy. Eventually, this led to rising inflation. The Fed attempted to contain inflation by sharply raising interest rates, which in turn led to market declines throughout 2022. As inflation got under control, markets rebounded again this year, but the impact of higher rates and still above normal inflation has led to uncertainty about what’s next. The economy was injured, received adrenaline to revive it, and is now still dealing with the hangover.
Hopefully what’s next will eventually be similar to the Great Expansion that the US economy experienced after the 2008 financial crisis. One big positive difference has been the much larger size and efficacy of government stimulus, which so far has been able to prevent the long, protracted recession we saw from 2007-2009. The negative side of that has been inflation and the jump in rates. If rates decline again quickly, the risk is reduced. But if rates stay high, the effects will ripple across the economy, impacting banks and other financial institutions holding bonds, commercial real estate that needs to be refinanced, consumer spending, and the US government budget (as more spending goes to pay the debt burden).
Whether the economy can still settle down into a stable recovery period remains to be seen. The Fed has a difficult balancing act as it seeks to normalize inflation and rates, but as noted in the beginning of this commentary, for now the economy may be more resilient than people give it credit for, buying the Fed some much needed time.