The Nvest Financial Investment Committee is pleased to present you with our end of third quarter 2023 Market Commentary. This commentary was also presented during our most recent webinar on the economy, presented on Wednesday, October 25th.
As a matter of two public announcements before we dive into the markets and the economy, The Nvest Group would like to draw your attention to our new website launched on October 2nd. Please go to www.planwithnvest.com for a look at our refreshed site.
Also, please note that The Nvest Group will be hosting its Holiday Celebration on the evening of Friday, December 22nd at Jimmie’s Jazz & Blues Club, 135 Congress St., Portsmouth, NH. Cocktail hour will begin at 5:00 and dinner will be served at 6:00. The event is RSVP-only. The event will feature Deep Blue C Orchestra. Please check your mail for more information and instructions for RSVP-ing.
When we discuss the current economic state of the country, it’s difficult not to notice what’s going on with several factors. Inflation, interest rates, and possible war in the Middle East are some concerning factors that may have you up at night. These certainly can have an influence on the stock and bond markets.
But before you reach for your Zzz-quill or that nightcap (of course, we do not encourage either, unless instructed by your physician), let’s break down a few key things going on in the economy which will help explain our investment position for client portfolios and how we believe we are positioned to take advantage of opportunities.
First, we must consider the country’s GDP, or gross domestic product. Simply put, the measure of all the goods and services the country produces (known as GDP) helps give us an idea of the direction of the economy, which ultimately helps define many other factors.
Although GDP was slightly down from the first quarter of 2023, second quarter GDP was up at an annualized rate of 2.1%. Third quarter GDP had not been announced as of our market commentary webinar (held this past Wednesday, the 25th) but was expected to come in at an even lower annualized amount. Surprisingly, the figure came out at a rate of 4.9% annualized as of the writing of this summary.
This carries some good and bad news with it. For one thing, it means the economy is doing well. However, on the other hand, it can very well mean that the economy is doing too well; well enough for the Federal Reserve to keep interest rates high for a bit longer because a heated economy contributes to higher inflation (more on this later) which is troublesome for everyone.
Meantime, corporate profits increased by about ½% in the second quarter, less than what was expected but certainly better than the 4.1% loss experienced in the first quarter. And with over 75% of the S&P 500 companies reporting earnings this earnings season, the majority of them are beating expectations, which had already been lowered for the year. Basically, companies are chugging along despite inflation pressures, wage increases and higher interest rates, all of which put pressure on profits. This is probably due to cost-cutting measures many companies have taken to adjust to this new norm of doing business. But news of their earnings is typically received by the stock market with a good amount of volatility.
On the topic of inflation, how bad is it? Well, it’s so bad that my neighbor got a pre-declined credit card in the mail. It’s so bad that CEOs are now playing miniature golf. And it’s so bad that when I called to get the Blue Book value on my car, they asked if the gas tank was full or empty!
All kidding aside, the rate for the month of September increased by about 3.7%, which is certainly down from its peak several months ago. But the quoted inflation rate doesn’t always reflect the price of every good you might be used to purchasing. There are different numbers quoted in the media, and this can cause confusion. There’s the headline inflation rate which is what you hear about in the news, then there’s the core inflation rate which is the rate of inflation excluding food and energy prices (which have come down somewhat after experiencing huge jumps due to, among other reasons, the war in Ukraine). And the core inflation rate is currently at about 6.3%. Regardless, these figures are far above the Fed’s target inflation rate of 2%.
Bottom line is we are all feeling inflation every time we go and buy something. Although the rate of increase of inflation may have slowed, prices have not gone down, which is why we are feeling inflation despite the “positive” news. Food costs have increased by about 20% in the last three years and if you’ve tried to purchase a car recently, you’ll see how much those prices have risen (about 29% since the start of the pandemic in March 2020).
Which explains interest rates… The Fed manipulates interest rates (well, one key interest rate called the Fed Funds Rate; the various other interest rates float based on market reaction) to ether slow the economy in order to combat inflation, or to get an economy going once it has slowed down.
When we think of interest rates, our minds may go to mortgage rates as an example. Today, a 30-year fixed mortgage is at an average rate of about 7.6%. Compare this to where the rate was about 2 years ago – rates then were around 3%! Of course, the cost of borrowing for a car, for business, for basically anything we do has gone up, all in an attempt to bring down inflation.
As previously stated, the federal funds rate is driven by the Federal Reserve. This rate defines the excess reserves banks must deposit at the Federal Reserve and the rate banks can lend each other money to meet reserve requirements. Think of reserve requirements as basically “cash on hand” the bank must have which is set by the Federal Reserve. Allowing banks to have a lot of cash fuels an economy (gets it going, and thus rates will tend to lower) or forces banks to take money out of the system (and thereby force interest rates up) in order to slow the amount of money that is out there (for example, during times of inflation like we have today).
Of course, employment issues have had their own effect on our overall economy. The unemployment rate is currently at 3.5% of those looking for work (adjusted to 3.8% for seasonal unemployment). This has remained about the same since March, helping feed into inflation as wages have been getting competitively higher to attract workers.
Despite all the ravages of inflation and interest rates, the US consumer has remained fairly resilient in 2023 with consumer sentiment slightly higher than last year and people continuing to spend throughout the summer. If you traveled anywhere this summer, you would have noticed people out and about, especially after having confined themselves during CoVid.
As for the markets, what appears to be is not always the case. How so? First, if we look at the broad market, we commonly refer to the S&P 500 which an index made up of roughly 500 companies (503 to be exact at this time) that are supposed to give us a sense of the broad market. In 2022, the S&P 500 was down roughly 18% (including reinvested dividends). But for this year through September, the same S&P 500 is up about just under 12%. One would think that the markets are doing well.
Mathematically, however, the markets are still down from the beginning of 2022 thru the end of September. And here’s the interesting part about that number which causes even more confusion to the investor and caution for us: just like anything, unless you dissect how the S&P 500 measures the return of the companies that represent the index, you would think that all stocks should be up.
The way the S&P 500 measures return is that companies that are big (referred to having a bigger capitalization) have more weighting or influence on the S&P 500 than companies that are smaller in capitalization. The result is that the return you hear of the S&P 500 can very well be due to only a handful of large companies, and indeed that’s been the case this year.
If you consider another index referred to as the “equally weighted S&P 500 index”, the year to date (ending September) return of this index is only slightly bigger that ½%. That’s ½% return compared to the S&P 500 return of about 12% over the same period!
Think of a pizza pie. Let’s say we cut up a pizza pie in 500 pieces. If each piece were different sizes and I told you I ate 7 pieces, you might think I didn’t eat a lot since 7 out of 500 pieces is just a small fraction of the pizza. But if I happened to eat the 7 largest pieces, I might have eaten a lot of that pizza. If the pizza were cut up in equal pieces, 7 pieces wouldn’t necessarily mean a lot of the pizza.
For investors who may not understand how the S&P 500 index they hear on the news considers returns, we may get the impression that the overall markets have done well this year. But the truth is only the 6 or 7 largest companies of the S&P 500 index have done relatively well while the rest of the companies in the index have not done so well. Similarly, you may have heard that tech stocks are all the rage this year. But the fact is tech stocks are still down more than 10% lower than where they were at the start of 2022 (again if we look at returns to the end of September).
As for the bond markets, as we are aware, interest rates on newly issued bonds, savings accounts and termed bank accounts (CDs, etc.) are up. The 1-year Treasury bill is at about 5.4% while the key 10-year Treasury note is at about 4.8%, having hovered in the last month between 4.6% and 4.8%. The 10-year is a key rate because mortgage rates, which are up, are indexed off of this key rate. And in general, it’s often considered that if the 10-year rate breaches 4.8%, we could be in a recession. What this would mean is the economy is slowing down, which would mean the economy would need a boost to get going again, which could very well lead to the Federal Reserve dropping interest rates (the fed funds rate). If and when this occurs, it could very well give the broader market (the other companies of the S&P 500 that aren’t currently doing as well as the handful of companies that are) to start going up again on a broader basis.
And interestingly, interest rates on the shorter end (the one-year Treasury) are higher than the longer term (ten year and even 30-year Treasuries). This basically means the market expects interest rates to fall at some point in the near future.
So, the question is, “What’s all this gibberish and statistical stuff mean to me, the investor?” Our job is to make sense of all the gibberish and market stats and to allocate you based on this information, where we believe the economy is headed and what your specific needs and tolerance for all of the ups and downs we’re experiencing.
Although it appears we’re heading into a recession in 2024, it’s difficult to tell. The Federal Reserve has taken a pause from raising rates, at least for now, but might do so again in early 2024 given how the economy is in an inflationary period. This causes confusion, if not panic, among the stock market (as well as investors) and thus the volatility we’ve seen.
Second, even if we enter a recession, that is not necessarily a bad thing. Investments continue to grow during a recession and if we’ve allocated some assets to the currently higher bond rates we see, we will be locked into those rates until maturity. In addition, stocks still grow during a recession and, in fact, with interest rates going down, companies now continue to grow since borrowing is cheaper and wages have steadied – all good things for the stock market.
We are very optimistic about the future and are even more confident of our current tactical allocation strategy which has called for lowering our exposure to equities on an overall basis. Although we continue to have some exposure to equities, this exposure is significantly lower, on average, for every portfolio. We also believe that we could be in for some more volatility this season, which is why we continue to keep our allocations for your portfolio the way we have it, but are in a very good position to take advantage of any drop due to economic issues, current news overseas, or the markets reacting to something that’s completely unforeseen (called the Black Swan theory).
Regarding current news overseas, who knows where we are headed? But if the US does get engaged in anything overseas, at least history has shown that war is not a necessarily bad thing for the markets. This may sound counterintuitive, but reality, and history, have shown that any involvement in any overseas military engagement has been positive for the markets, for the most part. Companies didn’t stop growing, producing and consumers didn’t stop spending money during WWII, Vietnam, Desert Storm or the Iraq/Afghanistan conflict. We’re certainly not advocating loss of human life, but the news, the media and current events should not scare us off from investing, even if we go through a rough patch in the last quarter of the year with a market drop. And, of course, history is not a predictor of the future; it is only a guide to consider.
Remember, market drops mean opportunities in the market. And while we await a good opportunity to revise our overall allocations and bring our equity exposure back up, our bond allocations in portfolios are spread across a number of different types of bonds as well as different maturities with some pretty good interest rates, all with the intention of diversifying the portfolio and taking advantage of the currently high rates.
What should you do now? The last thing you want to do is panic and be taken in by the media and its desire to sensationalize events with numbers that may not tell the whole story or aren’t easily understandable. Believing you’re “going to cash out now and get back in later” is not a disciplined approach to the markets unless you are a professional following all the statistics and data, and losing your confidence and discipline is never a good reaction no matter what we’re discussing.
Staying disciplined is the best approach and talking with your financial professional at Nvest is the best course of action you can take. Chances are excellent that given our advisor’s knowledge and understanding of your personal financial plan, your goals and objectives as well as your risk tolerance the way they understand you, we have allocated your portfolio in a way to a) weather the storm and b) take advantage of opportunities in the stock and bond markets as they navigate through the economy.
We wish you and your family a safe and happy season as we enter the holidays and invite you to call our office with any questions, concerns or anything that might be on your mind. We are here to listen and to help, one relationship at a time!
All the Best,
The Nvest Financial Investment Committee Team