Third Quarter Market Review
“When most people think about the future, they ignore that the future is a distribution of possibilities.” – Howard Marks, Oaktree Capital Management
Market returns are a distribution of possibilities. Market pundits seem to be on tenterhooks until the next Federal Reserve (Fed) meeting or until a Fed speaker issues his or her economic insight. Dot plots and rate hike possibilities tend to rule the day. Investment strategists grasp to inflation and labor data in a vain attempt to predict the one path that the Fed takes to arrive at its 2% inflation target, while simultaneously extrapolating that path’s impact on the broader equity and fixed income markets.
At Madison, we will freely admit to not knowing all the future possibilities let alone the one path the economy and market will take. What we do know is that we can understand what is happening in the market today, while understanding that quick theories derived from recent news tends to be detrimental to building long-term wealth. There are a multitude of economic and geopolitical shocks that can affect predictions. While writing this Insight, market expectations have whipsawed from the Fed hiking interest rates one more time this year, to possibly pausing for the year, swinging back to the possibility of another hike given the hotter than anticipated Consumer Price Index reading (which trended lower year-over-year but was higher than predicted leading to a negative market reaction). Markets can be exhausting!
The facts of the quarter are that following a 0.25% rate hike in July, the Fed is opting to wait for the data to tell them what approach should be taken as a softening labor market and inflation components (other than the stickier services inflation) trended lower during their September meeting. During that meeting, the Fed also dialed back their projections of future rate cuts in 2024 from 1% down to 0.5%, which prompted market forecasters to pound the drum on a “higher-for-longer” thesis.
Prior to this new interpretation of Fed policy, equity markets started the third quarter clawing their way closer towards the S&P’s all-time highs on the back of tech advancements (artificial intelligence) and the expectation of aggressive rate cuts in 2024. However, worries over Fed policy and the strength of consumer and business spending caused a sell-off in equities with U.S. equities finishing the quarter down a modest 3%. Despite this decline, global stock markets are still producing a double digit return on a year-to-date basis.
These current rate conditions also lend themselves to an environment where active management is seeing ample opportunity to generate returns through security selection. In an era of cheap financing, a rising tide lifted all boats (and indexes), as low interest rates allowed unprofitable companies access to cheap capital. During the third quarter, the dispersion between returns of individual stocks reached its highest level since 2010, as lower quality companies underperformed. In this new era of higher rates, businesses that are prudent allocators of capital and maintain high quality balance sheets could be advantaged over their peers. We have always tended to favor a quality bias through our subadvisor and security selection process and expect this to provide a tailwind to our portfolios in the coming quarters.
For the income-oriented side of the market, the aforementioned action by the Fed, as well as a rating downgrade of U.S. debt by Fitch from AAA to AA+, drove interest rates higher. This pushed total returns for the U.S. Bond market into negative territory for the quarter, though returns are still positive on a trailing one-year basis. On a positive note for fixed income, real yields (bond yields after accounting for inflation) are currently at their highest level in 15 years, and are beginning to see a flattening of the yield curve as yields on the 10-year treasury ticked up 0.7% over the course of the quarter. As we have written in prior quarters, the current fixed income environment is providing a viable alternative to equity investments (a trend that we have not seen in over a decade). Not only are we seeing yields on cash above 5%, we are also seeing an environment where longer-term fixed income presents an attractive risk/return profile. At its current levels, the 10-year treasury could weather another 0.5% increase in yields and likely still produce a positive total return. Conversely, if rates do decline, the wind would be at our back and provide possible capital appreciation to portfolios.
As has been our history at Madison, we are acutely aware that trying to map out all of the future possibilities and attempting to select the correct one is a fool’s errand, and that trying to time the market is a sure way to underperform it. So instead of betting on predictions, we will continue to hang our hat on working with our clients to understand their needs and build globally diversified portfolios tailored to those needs in order to navigate these possibilities and market paths.