Q3 2023 Market Commentary
Market Overview 3Q23
Market Recap
On the back of rising oil prices, fears of interest rates staying higher for longer, and a renewed focus on the prospects of a looming recession, equities pulled back starting in August. The S&P 500 index posted its first negative quarter since Q3 2022, declining -3.27% but remaining up 13.05% year-to-date.[1] Global stocks as measured by the MSCI ACWI declined -3.63% for the quarter and are up 9.96% for the year.[2] The overarching theme for the quarter was that the probability of a U.S. recession was rising, as the impact of aggressive monetary policy was taking its toll on the consumer and economy.
In July the Fed raised rates by an additional quarter of a point, marking the 11th time since March 2022 and a cumulative rate rise of 5.25% to date. At their September meeting, the Fed left rates unchanged, but signaled that future hikes were not off the table. Regardless, the Fed is likely at or near the end of its tightening cycle unless inflation reaccelerates. This should allow investors to gradually change their focus to the potential for future rate cuts in the quarters ahead. As a result of the rate hike and rising recession angst, long-term U.S. Treasurys suffered their fourth-worst quarter since 1926, plunging -11.8%.[3] During the quarter, the 10yr US Treasury Bond yield rose by .75% to end the quarter at 4.57%, its highest level since August 2007. Given that interest rates and stocks have moved in opposite directions this year, it seems an obvious catalyst for stocks will be lower interest rates brought on by softer economic data or a dovish Fed.
After nearly two years of hot inflation, a sustained inflation downtrend is now underway. Headline CPI has fallen from a peak of 9.1% y/y last June to 3.7% y/y in August.[4] Similarly, core inflation has continued to drift down after peaking eleven months ago. Overall, the U.S. economy is forecasted to continue to grow at a moderate, but slowing pace, and while a near-term recession is unlikely, a slower-moving economy will be increasingly sensitive to shocks.
Labor market strength is gradually easing and the pace of job gains, while still robust, has been trending lower since last year. Improved labor force participation has supported job growth thus far, with 25–54-year-olds having fully recovered to pre-pandemic levels. However, as we have noted previously, the U.S. has a structural challenge of aging demographics, which will continue to place a ceiling on labor supply growth and the participation rate. As a result, the unemployment rate should remain historically low until we see a material economic slowdown.
According to FactSet, the consensus third quarter earnings growth for the S&P 500 is estimated to trough this quarter with a decline -.01%, which would mark the fourth straight quarter of year-over-year earnings decline. However, looking to 2024, analysts are projecting a meaningful rebound in earnings growth of 12.2%. We believe next year’s earnings are likely too optimistic, which could create turbulence for stocks if expectations are materially lowered.
Investor Sentiment rebounded through July from the trough last summer as moderating inflation, resilient labor markets, and strong market performance boosted confidence. As the calendar turned to August, short-term sentiment began turning pessimistic on the heels of the July Fed rate hike. The gradual impact of higher borrowing costs and rising gas prices, which were exacerbated by OPEC production cuts, weighed on investors. The gloom that has caused investors to sell risk assets and sentiment to weaken helps reduce some of the frothiness in the market, potentially setting the stage for a sustained rally in the seasonally strong, final months of the year.
We enter the home stretch of the year with our asset allocation framework reverting to a moderately defensive posture. Entering the third quarter, we were gaining optimism for an improving investment environment; however, things soured within our framework during the quarter, particularly around Market Technicals. As we continue to work through an environment of conflicting information, we remain disciplined as new data is released and await confirmation from our asset allocation framework of a sustained improving environment to increase equity exposure.
What does history portend for Q4?
We shared a related table last quarter from Ned Davis Research highlighting the historical second half performance for the S&P 500 during similar first half performance environments. The table below takes this a step further by including strong 1H performance as well as weak Q3 performance.
From a historical perspective, when these conditions exist, the S&P 500 rose 80% of the time during the fourth quarter by an average of 6.8% going back to 1926. Furthermore, the fourth quarter has historically been the strongest quarter of the year for stocks by a noticeable margin. Since 1950, the S&P 500 has posted an average gain during the fourth quarter of 4.2%, materially outpacing the 0.6% average gain for the historically worst, third quarter.
While we cannot say whether history will repeat itself, early fourth quarter volatility would not be unusual, particularly given the additional looming factors of a government shutdown and the upcoming third quarter earnings season. As noted earlier, the direction of long-term interest rates is likely to serve as the key driver of stocks in the weeks ahead.
[1] Morningstar Direct
[2] Morningstar Direct
[3] Ned Davis Research
[4] Bureau of Labor Statistics