Cereus 3rd Quarter 2023 Market Commentary
David J. Haas CFP®
October 18th, 2023
The third quarter of 2023 has been a little difficult from an investment point of view. After the S&P 500 index rose 16.89% in the first six months of the year, the index dropped 3.27% during the latest quarter. The index is still up 13.07% for the first nine months of the year, but of course it has a long way to go to make up for the very poor performance last year. Rather than write a lot about market performance, I want to discuss interest rates, inflation, and bonds.
A Little Economics
Let’s start with inflation. Everyone who buys anything sees inflation. It is measured by the Consumer Price Index (CPI), which is a measure of the overall prices of goods and services in the economy. When the US came out of the pandemic shutdown, a combination of the economic stimulus and lingering supply and labor disruptions caused inflation to peak at a high of 8.9% in June of 2022.
The Federal Reserve Bank has two mandates: To control inflation and to maintain full employment. Employment currently is extremely robust, so the Fed is really concentrating on managing the high inflation left over from the pandemic. The Fed has declared that they want inflation to drop to 2%. That is enough inflation to keep the economy away from deflation (which is a worse problem), but not enough to cause other problems. While the Fed has several tools it can use to help control inflation, the most important one is their direct control of the short-term interest rate. The Fed sets the short-term benchmark funds rate, which was at 0.08% in February of 2020. They have raised the rate gradually, but rapidly to 5.33% as of today.
The Fed likes to use an inflation measure called Core PCE. PCE stands for Personal Consumption Expenditures and it is measured slightly differently than CPI. The core part means that it skips food and energy, two very volatile components of inflation. Core PCE had dropped from a high of 6.0% in the first quarter of 2022 to a current reading of 3.7%. That’s good news, right? Yes, it is, but remember that the Fed wants core PCE to drop to 2%. 3.7% is not 2% and getting rid of the remaining 1.7% needed to get to 2% may be much harder to achieve than the initial 2.3% drop.
Let’s now look at intermediate and long-term interest rates. Unlike short-term interest rates, these rates are set by the market and not by the Fed. In a healthy economy, intermediate and long-term rates are higher than short-term rates. The reason is that longer term bonds are riskier than shorter term bonds, so lenders require higher rates to pay for that risk. Intermediate and long-term rates are also set by an expectation of where the Fed might move short-term rates. If an economy is growing, the Fed might keep rates the same or raise rates to avoid overheating in the economy. This is called a positive yield curve.
Today though, we have a different picture. 1-month treasury notes are 5.56%, but 10-year treasury bond (intermediate) rates are 4.69% and 20-year treasury bonds are 5.0%. This is called an inverted yield curve. Why is the yield curve inverted? The most important reason is that the market is convinced that we will enter a recession in 2024 and the Fed will have to drop short-term rates.
Another important thing to understand is that when intermediate and long-term rates rise, the price of existing bonds drop, which means the value of bond funds that hold those bonds drop. Normally an investment portfolio uses bonds to create current income combined with stability. If stocks go down, at least bonds maintain their value, right? In a rising-rate environment, which is what we have had the past two years, the answer is no. Bonds dropped along with stocks. In some cases, long-term bonds dropped even more than stocks last year.
Investment Management in a Rising Rate Environment
It turns out that investment managers can make some tactical moves to lower the pain of bonds in a rising rate environment. We can lower the duration of the bond funds we hold to make those bond funds much less sensitive to rising rates. The problem is recognizing how far and how much rates are going to rise. At Cereus, we started lowering bond duration in portfolios in the middle of last year and we have continued to keep bond durations short. Now that short-term rates are around 5%, bond investors are getting income from their bonds and once again they can become the ballast in the portfolio. The short duration of the bond funds means rising rates will not cause the funds to drop much if at all. The question is, are we still in a rising-rate environment and should we continue to keep bond duration short?
I follow some economists who believe that higher inflation will be with us longer than expected and that the economy is robust enough that we will not be in a recession next year. This probably means longer term rates will continue to rise and short-term rates are not going to drop for the foreseeable future. I agree with this theory and plan to keep the short duration tactical shift in portfolios. Since short-term rates are higher anyway, we are all being paid to wait.
What will happen the rest of the year? Here is my prediction (similar to last quarter):
- The US will escape recession in 2023 and 2024. Economic growth is more robust than people think and that will keep unemployment low. A recession could come by 2025 though.
- Inflation will stick around for the rest of the year and that means the Federal Reserve Bank will raise rates again this year and certainly not lower rates. The bond market is expecting a rate cut early next year, and that is increasingly unlikely. This means long-term rates will rise more, reducing bond prices.
- Corporate earnings seem to be surprising the market to the upside for the 3rd This could create a stock rally after the usual October turbulence. There also will be money to be made in other components of the stock market including international, emerging markets, and value stocks.
- The Federal Reserve Bank will stop raising rates by the end of the year even though inflation will be above 2%. They may give an excuse, but the real reason is that the Fed does not want to see a recession in an election year because they will take the blame.
As always, you should be focused on the long term with your investments. I can’t guarantee any of my predictions will come true. Perhaps I am too pessimistic, or perhaps too optimistic. Good things can happen when you least expect it, and sometimes the bad things are not as bad as you expected. Please feel free to contact Mike or myself with questions about your portfolio, investing in general, or economics.
I have talked a lot about the expected performance of stocks and bond funds. I want to remind you that investing always involves risk. Investment performance may not happen the way you or I expect, and wars or other kinds of shocks can cause unexpected things to happen. Nothing I have written here should be taken as any kind of personal recommendation since everyone’s situation is unique. You should talk to your financial advisor.