Fear is the best fertilizer for future bull markets.”    Jason Zweig

Third Quarter Summary

Compared to the first half of the year, almost all financial assets pulled back during the third quarter. The correction included domestic and foreign equities and bonds, most commodities, precious metals and currencies.

The US dollar and oil were exceptions that rallied over the summer. Although September has been a traditionally weak month, it was even more so this past decade, with the S&P 500 falling 3.8%, 4.7%, 9.2% and 4.8% from 2020 through this year.

The swoon in financial markets occurred despite the continuing resiliency of the US economy. Real GDP growth, consumer spending and employment continue to be indicative of the expanding economy. These factors weighed on inflation, which drifted lower at a pace too slow for the Federal Reserve. The short-term Federal Funds Rate had increased only once in July from 5.25% to 5.50%, with the US central bank being data dependent on the future course of interest rates.

Meanwhile, longer-term rates increased, with the 10-year US Treasury rising 73 basis points to 4.57% by quarter’s end, as investors finally realized the “higher for longer” rate strategy of the Fed was real, and the economy was showing few signs of an imminent recession.

Economic Struggles Continue Abroad and at Home

Even after the Covid lockdown was lifted in China earlier this year, the country’s economic growth has continued to disappoint market strategists, with its struggling real property sector (comprising 25-30% of the Chinese real GDP) dragging down consumer spending. Note that residential homes and apartments make up the bulk of net worth for the average Chinese household. Moreover, unemployment among young people has risen above 20%.

In addition, debt from an overleveraged property sector, rising unemployment and an unfavorable demographic situation (the Chinese population has been decreasing) has impacted trading partners as well. This applies to European Union countries such as Germany, in particular. The US, which is not as dependent on trade, has largely been spared most of the pain.

However, there is widespread discontent among consumers regarding gasoline prices and inflation in general. West Texas Intermediate petroleum prices spiked over 28% to $90.79/bbl., with Brent prices even higher. The OPEC+ coalition (OPEC plus Russia) has proven durable, with the Saudis extending their 1 million barrel per day cut, thereby restricting supply. Though the rate of inflation is coming down slowly, prices are still rising, and the cost of goods and services remains well above pre-pandemic levels.

At home, wage issues continue with numerous strikes such as the Hollywood actor’s and UAW strikes and large wage hikes for transportation companies posing a dilemma for the Fed in its quest for 2% inflation. Meanwhile, the US dollar has rallied again as relatively stronger economic growth, along with higher interest rates relative to other countries, has bolstered the greenback.

Investment Outlook for the End of the Year

  • The Fed is near the end of its tightening cycle, with one or two rate increases possible. Of greater importance is the length of time that rates will stay elevated.
  • Our belief is that rates will stay high well into 2024. Inflation remains somewhat sticky because higher wages, oil and other factors such as conversion to alternate energy, will not fall quickly.
  • The economy will slow, as consumer spending is crimped by higher prices and borrowing rates. The resumption of student loan payments will be a contributing factor.
  • Taking all of this into account, there is a 50-50 chance of a recession commencing by next spring. Even if one does occur, however, we feel it will be mild, due to better consumer and corporate balance sheets than previous downturns.
  • Also mitigating the decline is a labor market based on a structural shortage of workers, especially skilled laborers.
  • Finally, some sectors will continue to experience rolling recessions while others recover. This will help cushion the overall impact of an economic contraction.

Our portfolios have been positioned for some time to manage a slowdown, investing in companies that are leaders in their industries, with most equities currently slanted toward growth. Fixed income retains a barbell approach, offering the flexibility to pivot when economics conditions cause a change in the yield curve.