The Quarter in Review | 3Q 2023
THE COMEBACK OF VALUE STOCKS DESPITE GLOBAL EQUITIES’ DRAWDOWN IN Q3
Global stocks dropped after last quarter’s positive performance, with the MSCI All Country World IMI Index returning -3.4% over the quarter. The 5-year forward inflation expectations in the United States remained below 3% for the quarter, as the yield curve has remained inverted for more than a year. In particular, the 10-year Treasury yield rose by nearly 80 basis points to 4.6% this quarter, marking its highest level in approximately 16 years.
Globally, energy rebounded from its weaker performance in the first half of 2023 and was the best performing sector, returning 11.5% for the quarter. Comparatively, information technology, REITs, and utilities lagged the overall market. Large growth stocks were the biggest detractors, as Apple declined -11.6% while Microsoft also dropped, down -7.1%. Value stocks generally outperformed growth stocks across U.S., non-U.S. developed, and emerging markets, with the MSCI All Country World Value IMI Index outperforming its growth counterpart by 3.1%. In the U.S., the value premium was positive despite generally negative size and profitability premiums.
The value premium in the United States and globally was strong for the quarter, as value stocks outperformed growth stocks in every region and generally across small and large caps. The value premium was especially strong within developed markets outside of the U.S., with the MSCI World ex USA Value index outperforming the MSCI World ex USA Growth index by 8.4% for the quarter.
FIXED INCOME
U.S. Treasury yields climbed higher in the third quarter as the Federal Reserve continued to raise its benchmark interest rate. After a rate increase in July, the Fed held rates steady in September and October but left the door open for further rate increases in the future. With yields at the highest they’ve been in 15 years, it appears “higher rates for longer” will continue to be the expectation. However, this is highly dependent on ongoing inflation. If inflation continues to flatten out, interest rates should stabilize and possibly move down over time.
In terms of total returns, the U.S. Aggregate Bond index declined -3.23% for the quarter and is now down -1.21% year to date. It appears the Bond Index could be in line for an unprecedented third straight year of negative returns.
ALTERNATIVES
Demand worries in the U.S. and China weighed broadly on commodities, notably metals and energy. The markets grappled with whether the Federal Reserve’s aggressive monetary policy tightening will put the U.S. into a recession. Led by a 30% return in Crude Oil, commodities bounced back in the third quarter with the Bloomberg Commodity Total Return Index gaining 4.71%. Natural Gas and Wheat were the worst performers for the period, declining -10.4% and -20.02% respectively.
After a respite in the second quarter, as interest rates resumed their march upwards, U.S. Real Estate Investment Trusts (REITs) sold off -7.40% for the quarter and are now down -2.05% year to date. Global REITs continued to decline weighted heavily by China’s struggling property sector and bankruptcy filings of Evergrande and Sunac, two of the country’s largest property developers.
ECONOMY
The “economy” is often discussed in rather simplistic terms driven by a few key parts (inflation, unemployment, interest rates and GDP). The reality is the economy is much more complex, some parts independent and others interrelated. Some astute economists have pointed out that we have “two different economies” at play. The services sector continues to show growth while the manufacturing sector is indicating a recession. Thankfully, manufacturing’s share of employment is only about 8%, while the services sector accounts for approximately 78%.
The Fed’s hike in interest rates and its quantitative tightening (reducing its balance sheet) continue to result in a hiring slowdown for both small firms and the broader economy. The labor market appears to be softening, with hours worked, overtime hours and temporary staffing levels all declining. The number of people voluntarily leaving their jobs for another position has dropped to the lowest level since the beginning of 2021. Unemployment continues to stay low with October’s unemployment rate coming in at 3.9%. For perspective, during the Great Financial Recession in 2007-09 unemployment reached 10%.
That being said, the economy was much stronger in the third quarter than anticipated. Real GDP (meaning adjusted for inflation) grew at a 4.9% annualized rate. Details always matter, and in this case a large component of the growth was bolstered by a 7% annualized increase in government spending. This combined with an $80 billion increase in inventories (goods produced but not actually sold) helped push growth above expectations.
Another area contributing to stronger than expected economic growth is the resilience of, or addiction to, consumer spending. Despite a low savings rate, slowing demographics, depressed confidence, a crippled housing market, rising interest costs and growing credit problems, it is estimated that American consumers increased their inflation-adjusted spending by more than 4% annualized in just the third quarter. This is somewhat baffling when you look at the index of consumer sentiment which fell to 63 in October, a rating in the lowest 10% (bad) of all time since tracking began in 1978.
GROWING GOVERNMENT DEBT
The federal budget deficit is estimated to be about $1.7 trillion for fiscal year 2023, this compares to $946 billion for fiscal year 2022, so almost doubling in one year. One quarter (25%) of all U.S. government debt outstanding has been added since the beginning of 2020 with the total now approaching $35 trillion. Higher debt levels and higher interest rates have increased debt servicing costs from $1 billion per day in 2020 to almost $2 billion a day in 2023. Given the current trend line, annual net interest payments may soon overtake what the government spends on defense.
LOOKING FORWARD
Historically, aggregate stock market valuation ratios have not been strong predictors of broad market returns. And yet, high stock valuations sit near the top of concerns cited by investors about the state of equity markets. However, this perception stems from a subset of stocks. Investors should be careful not to throw the baby out with the bathwater by ascribing this characteristic to the broader global stock market.
The poster child for high valuations – the so-called Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Telsa) had an aggregate price-to-book (P/B) ration of 11.89 as of September 30 (despite six of the seven having lower profitability than the S&P500 Index). To put that in perspective, the average for the U.S. market over the past 30 years is 3.05.
These stocks have helped push up the P/B ratio of the tech-heavy Nasdaq composite to 5.21. Other broader indices such as the Russell 3000 approximates the total U.S. market trade at a more reasonable P/B ratio of 3.50, and the MSCI All Country World Index is well below the 30-year market averages with a P/B ratio of 2.43.
An additional consideration in evaluating where and how to invest, one has to ask the question – how long can the Magnificent Seven stay magnificent?
As companies grow to become some of the largest on the U.S. Stock market, their returns can be impressive. As shown on the graph below, not long after joining the Top 10 largest by market cap, these stocks, on average, lagged behind the market.
From 1927 to 2022, the average annualized return for these stocks over the three years prior to joining the Top 10 was more than 25 % higher than the market. However, three years after joining the Top 10, these stocks were, on average, underperforming the market – a stark turnaround from before. The gap is even wider five years out.
SUMMARY
No matter how familiar we are with investing or how long we have been at it, we’ve all navigated uncertain times. These are the challenges and realities of investing. Which is why we all need reminded, regularly, of a few key principles as we navigate uncertain times.
Uncertainty Creates Opportunity. Uncertainty can be uncomfortable. But we often forget that without it there would be no opportunity. When you invest, returns are compensation for taking on uncertainty. Without risk there would be no reward. But there’s also risk in choosing not to invest, because if your money doesn’t grow over time, it won’t go as far in the future. Cash hidden under a mattress can’t keep up with inflation.
Plan, Don’t Predict. We’ve all tried to predict what will happen in life, only to be disappointed when it didn’t turn out the way we anticipated. Investing is similar. For maximum peace of mind, we make plans that account for a broad range of possible outcomes. Plan for what’s possible and can happen, rather than trying to predict what will happen.
Harness the Power of Compounding. Even the small, seemingly inconsequential decisions we make every day can have a big impact over time. The best way to stay motivated and focused is to remind ourselves of the rewards that come from patience and commitment. Incremental gains every day can add up to a lot of progress over time. The same is true of investing. Your financial plan and investing results are the result of the cumulative effects of the decisions you make every day.
Control What You Can Control. In investing, you can control how much you save, the risk you take on, and the guidance you seek in putting together an investment plan that’s right for you, but you cannot control the ups and downs. Focus on what’s in your control.
Tune Out the Noise. We all know that markets rise and fall. We can be disappointed by downturns, but we shouldn’t be surprised by them. Reacting emotionally to recent market volatility may be more detrimental to your portfolio performance than the drawdown itself. Cultivating a disciplined and well-thought-out plan can help you tune out the noise. When it comes to investing, a lot of things are interesting without actually being meaningful or helpful.
Remember, we’re here to help. This also is where the time invested upfront with each of you shows its value. Formulating a solid and adaptable financial plan together and discussing liquidity, cash flows, and reserves provides the solid footing needed for times like these with many changing facets.
We appreciate the opportunity to work with each of you. We recognize that each client’s situation is unique and incorporates different factors into their investment and financial plan.
As always, if you have any questions or concerns about current market trends and the impact on your personal situation and plan, please contact us and we would be happy to discuss.
Please follow this link to read the complete Quarterly Market Review (QMR) - Q3 2023.