October 28, 2023
The end of the third quarter of 2023 saw higher interest rates and some softness in equity prices. On a year-to-date basis, stock performance was still positive through the end of September, but the major indices all logged negative results in the third quarter, with much of the declines coming in the month of September as interest rates spiked. The Dow Jones Industrial Average gained 1.1% year-to-date through September, the Standard and Poor’s 500 Index added 11.7% and the Nasdaq Composite was up 26.3%, after losing over 33.0% last year. During the third quarter, the DJIA lost 1.3%, the S&P declined 2.1% and the Nasdaq fell 2.7%. September was particularly difficult for the three major indices, as yields on the benchmark 10-year Treasury started to reflect the Federal Reserve’s messaging that interest rates were likely to remain “higher for longer.” Higher interest rates usually are detrimental to equity returns, and the third quarter of 2023 certainly gave us higher interest rates. The yield on the 10-year Treasury was 3.8% at the end of June and had moved to 4.6% by the end of the third quarter. By the third week in October, the 10-year note’s yield had reached 5.0%. This was a very abrupt move for the usually staid investment benchmark. In fact, bond volatility surpassed equity volatility during the third quarter, which is uncommon.
The world is a messy place these days, with gridlock in Washington, a looming funding battle on November 17th, the Ukraine War continuing to grind away, the Middle East facing impending chaos, Europe on the verge of recession, and China facing a deceleration of economic growth. Our domestic headline numbers look solid, with a strong September GDP print (+4.9%) and a very tight labor market (unemployment rate of 3.8%), however consumer sentiment is low. Although inflation has improved markedly since June of last year (see Exhibit 1), the core rate of inflation is still well above the Federal Reserve’s long-range target of 2.0%. The bond market is doing some heavy lifting for the Fed, which has driven long yields to their highest level since 2007 (see Exhibit 2). Additionally, although the equity markets are still generally above last year’s levels, they have declined into correction territory (i.e., down 10%) from their most recent highs. The most significant driver of equity markets has been the performance of a handful of mega-capitalization technology stocks. Through last week, the S&P 500 Index was up 14%. The S&P 500 is a market capitalization weighted index, meaning the larger market-cap components have a disproportionate influence on the performance of the Index. If the S&P 500 were equally weighted, representing the average performance of all the individual components, the Index would be flat for the year (see Exhibit 3). To illustrate the influence the large market cap names, consider that the largest 25 components of the S&P 500 accounted for 44% of the total value of the Index, 94% of the year-to-date return of the Index through the end of September, and the 25 companies traded at a 47% valuation premium (Price/Earnings ratio) to the other index components.
We have not seen such a valuation bifurcation since the days of the Nifty Fifty in the 1970s, when the market favored so-called ‘one-decision stocks’, whose future was so certain that they would never need to be sold. For those of us old enough to remember, recall that Simplicity Pattern, a maker of sewing pattern guides for household sewing, was one of the Nifty Fifty stocks. That did not end well.
As we mentioned, the Bureau of Economic Analysis released its “advance estimate” for third quarter growth on October 26th. Gross domestic product accelerated to a 4.9% annualized rate, more than twice the second-quarter rate of growth (see Exhibit 4). The increase in real GDP reflected increases in consumer spending, private inventory investment, exports, state and local government spending, federal government spending, and residential fixed investment that were partly offset by a decrease in nonresidential fixed investment. The increase in consumer spending reflected increases in both services and goods. Within services, the leading contributors were housing and utilities, health care, financial services and insurance, and food services and accommodations. Within goods, the leading contributors to the increase were other nondurable goods (led by prescription drugs) as well as recreational goods and vehicles. With such a strong topline economy, why are consumers and investors cautious? We have some ideas.
During the earlier part of the pandemic recovery, real wages did not keep up with consumption expenditures (see Exhibit 5). Even in the last reported quarter, real disposable personal income declined 1.0%, in contrast with an increase of 3.5% in the second quarter. The personal savings rate also declined in the quarter, to +3.8% from +5.2% in the second quarter. While a strong employment market is supportive of consumption, declining checking and savings accounts are not (see Exhibit 6). Since the fourth quarter of 2019, only the highest income quintile is showing much inflation-adjusted growth in checking and savings deposits (up 12%). The personal savings rate is declining as credit card debt balances expand (see Exhibit 7). Given the decline of pandemic-related savings and the miserable experience of real wage growth last year (see Exhibit 8), it is not that surprising that consumers are cautious about spending dollars that have depreciated 17% in the last two and a half years.
Wage growth and declining inflation rates will do a lot to improve consumer sentiment, all else being equal. Stocks for the most part are close to fair value, and short-term bonds are attractive. It is important to keep asset allocations appropriate for your risk tolerance and age. We will keep an eye out for bargains as they present themselves.
Your Team at Baxter Investment Management
We are excited to announce that Baxter Investment Management will celebrate its 100 year anniversary in 2024 and we wanted to thank our clients for their continued business and partnership!
S&P 500 Equal Weight vs. Cap-weighted Performance
Long-term Average Earnings adjusted for Inflation