Traditional asset classes posted negative returns in the third quarter as higher oil prices, a bump in inflation, and a re-calibration of monetary policy grabbed headlines. The S&P 500 and AGG bond index were both down 3.2% in Q3, while the MSCI Foreign Developed Index declined 4.6%. Returns were challenged by higher interest rates, primarily within long maturity bonds, which results in lower bond prices and can cause a recalibration of equity prices. While financial assets took a breather last quarter, returns over the last 1, 3, and 5-year periods remain attractive and above our internal targets for long-term growth, and we believe that will continue.
Uneven Performance in the S&P 500
The S&P 500 was up 13.1% in 2023 through the end of the quarter, an attractive return. Yet, stock market returns have not been equally shared by all stocks in the market. In fact, only 7 stocks, all of which are top-10 weights within the index, contributed over 93% of the S&P’s total return. If you assign an equal weighting to each of the 500 stocks in the S&P instead of weighting them based on their value, the S&P would only be up 1.7%. In fact, other equity indices we monitor, such as the Dow Jones Industrial Average and Russell 2000, are having modest years, up only 2.5%. We are glad we allocate significantly to the 7 stocks that have done well this year, but we intentionally allocate to dozens of other stocks to lower our concentration risk. While this results in underperformance relative to the S&P in periods of concentrated returns, we believe the added diversification reduces risk throughout market cycles. In fact, the “Magnificent 7” trade at around a 50% premium to the average stock and have largely recovered their 2022 losses, whereas other stocks remain well below record highs. S&P 500 exposure remains a core component of our target asset allocations, but we think it’s prudent to trim allocations to the top-heavy parts of the S&P and allocate to other areas of the equity market and income producing assets.
The Role of Rising Interest Rates
The primary catalyst for lower returns during the quarter was a continuation of the upward trend in long-term interest rates. The 10-year Treasury rate rose from 3.81% to 4.59% during Q3, a swift move higher. An increase in interest rates entices investors to sell riskier assets (stocks) because they earn a higher return on “risk-free” investments, such as T-bills or other Treasury bonds. While higher rates result in lower asset prices, they also mean better returns in the future. In fact, income producing assets such as bonds, utility stocks, and defensive equities are all paying the highest yields in over a decade. Furthermore, the why behind the recent rise in yields is for a good reason; the economy is much stronger than expected due to a tight labor market and consumers continuing to spend. The unemployment rate remains low, at 3.8%, and wage growth is outpacing inflation. Speaking of inflation, it has declined from 9% last year to ~3.5% in August, and market and survey-based inflation expectations remain well behaved. Overall, this suggests the recent rise in yields is because the economy continues to outperform, which means monetary policy must remain restrictive until inflation declines to 2%.
Tactical Positioning
While monetary policy may remain restrictive through early-2024, we believe the need for restrictive policy will decrease over the coming months. For one, higher interest rates themselves hinder economic growth, thereby lowering aggregate demand and upward pressure on prices. This has not happened yet, because higher rates affect final demand with “long and variable” lags, as Fed Chair Jay Powell routinely points out, but they will appear. Second, the Fed’s dual mandate of full employment and price stability will be satisfied once inflation comes down to the Fed’s target. While most inflation indices show a rate of ~3.5%, generally acknowledged mathematical inaccuracies within inflation data overestimate the true rate of inflation. The Fed has yet to recognize these inaccuracies and is instead waiting for the data to show 2% inflation. Waiting for this means keeping rates too high, in our opinion, and increases the risk of an accidental recession. Given that possibility, we continue to favor leaning into defensive assets, which as I mentioned above, are paying yields 3-4x just two years ago. We believe this gives us balanced exposure to assets with decent upside/downside prospects, which will outperform if the economy weakens. Furthermore, if the economy remains strong and rates remain high, our positioning in short-maturity bonds allows us to clip higher yields and quickly reinvest into higher rates. Overall, we are pleased with the strong S&P 500 return year to date but recognize this is not the typical experience for most of the stock market this year. Given the relative outperformance of mega-caps, the rise in bond yields, and cheapness of defensive sectors of the market, we think now is a good opportunity to trim winners, add to losers, and assess risk comfort before anticipated weakness materializes. We remain focused on maximizing client risk-adjusted returns, which means maintaining diversified allocations, even when returns are concentrated, and managing risk exposure before they become a problem.
Jeffrey Cone, CFA® CAIA®
CHIEF INVESTMENT OFFICER
