After a strong start to the year, driven from a narrow group of leading stocks, equity markets pulled back during the third quarter.1 While rising interest rates, above target inflation, concerns of a government shut down, and higher energy prices have contributed to a market slowdown and recessionary fears, the economy appears to be remaining resilient.
We are beginning to see the impact of rising interest rates on consumers as the 10-year Treasury yield has increased significantly – rising from 3.81% to over 4.50%2. The shift upwards in the Treasury yield curve potentially signals waning optimism.3 30-year mortgage rates are now north of 8%, which makes housing affordability more difficult.4 As a result of rising rates, housing delinquency rates and both car and consumer loans interest payments have increased which has further stretched the individual consumer.5 Households are expected to run out of excess savings accumulated during Covid during first quarter 2024.6 This, coupled with student debt payments restarting in October after a two-year pause could potentially push the economy to roll over.
The government shutdown, which was resolved at the last minute on September 30th, added stress to both the market and economy. At the 25th hour House Republicans and Senate Democrats came to agreement on how to fund the government for the fiscal year.7 A failure to reach a budget resolution would have forced the government to shut down on October 1st. The potential shut down put a spotlight on the one of the most pressing and under followed issue – government debt has ballooned to $33 trillion and now stands at 98% of Gross Domestic Product (GDP).8 If this continues unchecked, eventually there will not be enough revenues to cover the interest payments on the federal debt. These worries have pressed on the markets. Ironically, it’s the series of government stimulus that was passed over the last year for semiconductors, renewable energy and infrastructure spending that has been helping sustain the equity markets and overall economic activity.9
Increased attention to weight loss drugs such as Wegovy and Mounjaro impacted several sectors during the quarter. Novo Nordisk originally created Ozempic to treat Type 2 diabetes, but it has also been used off-label for weight loss.10 A sister drug approved specifically for weight loss, Wegovy, has been shown to suppress appetite and reduce body weight by 15% to 20%.11 Eli Lilly’s weight loss drug Mounjaro is gaining popularity. It is estimated that weight loss drugs could reach $1 trillion in sales.12 As a result, several sectors have sold off on the possible impact that these drugs could have on eating habits and health care. Food and beverage, medical device and insulin pumps makers have pulled back because of the growing popularity of these drugs.13 While it remains early to pinpoint the most likely benefactors and who could be most disrupted by this trend, we continue to monitor the developments and potential impacts around these drugs.
Litigation of major companies and the uncertainty of potential jury awards affected the market during the quarter. Johnson & Johnson, which recently spun off its consumer products division, reached an agreement to pay $8.9 billion related to talcum powder claims that it had caused cancer after a decade or more fight.14 Lawyers are increasingly trying to go after big companies to win big jury awarded payouts. The most recent being Tylenol use during pregnancy.15 As this trend continues, it creates additional risks for larger companies. As such, we are considering this as part of our risk assessment, analysis, and research.
The commodities index rebounded in the third quarter primarily due to a strong 25% rally in oil prices, which are now hovering above $90/barrel.16 Saudi Arabia, the world’s second largest oil supplier and part of the Organization of the Petroleum Exporting Countries (OPEC+), has cut production by 1 million barrels a day since July and will extend the cut through the end of the year.17 Russia, the third largest oil supplier, also extended its own cut of 300,000 barrels a month through year end.18 Tighter supply has resulted in higher prices although we have not yet seen a pullback in overall global oil demand. Iron ore has also rallied and is up 7% for the quarter.19 Steel demand hasn’t significantly picked up, but Chinese mills are continuing to produce to replenish low inventories.20 The increase in energy prices has been a driver of higher inflation.
U.S. Equity Markets
All U.S. equity markets underperformed for the quarter, with large cap stocks holding up better than mid and small cap stocks.21 Value outperformed growth with the energy sector leading the way, benefitting from higher oil prices. Communication services were also positive, driven by Charter and Comcast specifically. These companies are beginning to see broadband share losses subside while other parts of their businesses pick up. Conversely the bond proxy sectors, REITs, and utilities were the worst performing sectors during the quarter. Rising interest rates have impacted their balance sheet structure and are competing against fixed income as a viable alternative. Technology underperformed for the quarter after a strong start to the year. Growth rates for technology firms are coming down. At higher valuations many technology firms were vulnerable to a sell off.22
U.S. Fixed Income
The bond market has seen increased volatility as interest rates have increased.23 This has been especially true for longer dated bonds. Clients have benefitted from holding shorter maturity Treasury bonds given that yields have been in the 5% to 5.5% range.24 The leveraged loan and high yield markets had positive performance with yields ranging from 7% to 10%.25 U.S. junk bond default rates have started to increase. They will most likely continue to go higher but remain below the default levels that occurred in 2008.26 We believe that we are nearing the end of the interest rate hiking cycle, which means that real interest rate yields are positive. Our expectation is that the Fed will have to cut interest rates in 2024 to act against a slowing economy which will cause a rally in bonds.
Inflation levels, as represented by the Consumer Price Index (CPI), remain elevated above the Feds targeted 2% annualized level.27 In August, the most recent CPI reading was 3.7% annualized28, which was a step up from the prior two months. This was primarily driven by higher energy prices. The Personal Consumption Expenditures (PCE) Price Index, which is a slightly different way of measuring inflation, has shown a sharp decline in goods inflation, while services inflation continues to remain high.29 We continue to believe that inflation remains a bit sticky and that a recession may be the only answer to bringing the levels down.
Interest Rates/Fed Reserve/U.S. Economy
The Fed increased interest rates eleven times from March 2022 through September 2023, in one of the fastest rate hiking cycles in history. The Federal Funds targeted interest rate is between 5.25% and 5.5%.30 At the September Fed meeting, the committee agreed to pause on interest rates to see the full effect on the economy. The 10-year Treasury yield is now at its highest level since 2007. There is potential for the Fed to increase rates one more time in 2023 and the markets believe that the Fed will cut at least two times in 2024.31 In our opinion, the economy will have to weaken significantly before the Fed starts cutting interest rates given that inflation is still above its targeted 2% level. While the U.S. economy has remained resilient, we are starting to see economic indicators roll over. Job opening levels and wages are softening, bank lending has been tightening since the Silicon Valley Bank collapse, credit card and auto delinquencies increasing and manufacturing has been weak. Consumers spending through their Covid savings coupled with the return of student loan payments could put added pressure on discretionary spending. Many economists are forecasting more economic weakness.
China’s economy has been struggling and expected GDP growth continues to decrease. The 2023 GDP forecast has been lowered to 5% from 5.5% expected in July.32 China is faced with a large amount of debt due to infrastructure and property downturn. Evergrande, a property developer, has filed for bankruptcy and another, Country Garden, is expected to default. China’s property market is one of the largest in the world and 70% of Chinese household wealth is tied up in the ailing property market.33 China is also seeing the impact of rising youth unemployment, weak consumption, and export demands. Analysts are not expecting big stimulus programs for China as many local governments are indebted.34
Europe’s economy is weakening primarily due to the same concerns as the U.S. 2023 GDP growth for the
Eurozone is projected to be 0.8%.35 The largest economy in Europe is Germany, which is expected to be slightly negative for the year. Higher inflation, higher interest rates and reduced consumer spending have been the primary culprits of the lower GDP growth. Inflation for the 20 European countries is expected to be 5.67% for 2023 and 2.9% for 2024.36 To bring down inflation over the last year the European Central Bank (ECB) and Bank of England (BOE) have steadily increased interest rates to the highest levels since 2007. The ECB raised the bank’s deposit rate to 4% in September, the 10th increase in a row 37, while the BOE kept the bank rate at 5.25%.38
We remain cautious at this point in the market cycle. We are observing what we believe to be late market behavior that usually happens before a recession occurs. Strength in interest rates, US dollar and energy have typically been pre-cursors to market downturns. With bonds reaching the upper end of rates for this period, we could potentially see better performance from fixed income. While we remain defensively positioned, we are working hard to line up stocks that could be interesting coming out of a recession and help drive performance in the market cycle.