ACG Market Review – Q3 2023
- Economy – The unexpected strength of the economy has caused the near term probability of a recession to plateau
- Equities – Markets experienced a temporary halt in their upward trajectory, despite prevailing economic optimism
- Fixed Income – Bond yields continue to rise, but the potential for rate cuts is on the horizon
The Fall: Recession Probabilities and Markets
The global financial situation in the third quarter of 2023 was a complicated mix of economic forces and market trends. At the beginning of the year, against a backdrop of deteriorating economic indicators, banking industry concerns, and a hawkish U.S. Federal Reserve (“Fed”), a significant portion of economists predicted a recession within the next 12 months. However, following a series of positive surprises, recession probabilities have declined, and consequently, the projected timeline has been pushed back to 2024. Despite a brighter economic outlook, both the equity and fixed income markets posted negative returns in Q3. With global interest rates reaching long-term highs, investors may have finally adopted a “higher-for-longer” mindset. A surging oil market and a lackluster recovery in China also contributed to dampening investor sentiment. As the global economy marches forward, investors and policymakers alike would do well to proceed with a prudent blend of optimism and caution.
Indicative of the impact of 18 months of interest rate hikes by the Fed, the number of available job opportunities has declined to its lowest point in two years. As businesses are beginning to feel the effects of financial tightening, many have removed job postings. This produces the Fed’s desired result of easing some of the upward pressure on wages. Importantly, to date, layoffs have remained limited, with the unemployment rate hovering around 50-year lows. Absent a significant recession, there is a projected limit to how much the unemployment rate could rise, as U.S. businesses are confronting structurally slower labor force growth due to diminishing legal immigration and baby boomers reaching retirement age. Strong employment conditions should provide consumers with a protective buffer and increase the likelihood of avoiding a recession despite a decline in labor demand.
Additional positive economic indicators include robust corporate profits and GDP figures, both of which have surpassed expectations. The Atlanta Federal Reserve’s forward-looking GDPNow model estimates a near-5% annualized growth rate for Q3 2023. This impressive figure stands in stark contrast to initial expectations of most economists and investors earlier in the year, considering the backdrop of aggressive rate hikes implemented by the Fed since early 2022. With the unexpected strength in the economy, the consensus probability of a recession in the near term has plateaued and even declined, according to some prognosticators. Recently, Goldman Sachs lowered their 12- month ahead recession probability to 15%, noting the positive labor market and better inflation news. Although there is no certainty regarding the occurrence of a recession in the near future, it is crucial to acknowledge that a decelerating economy is more vulnerable to unforeseen difficulties.
Equity Markets Pause Despite Economic Optimism
During the third quarter, equity indices largely declined, with September being particularly challenging as the S&P 500 finished down -4.77% for the month. The index was down -3.27% for Q3 and is up +13.07% year-to-date. In terms of style, value outperformed growth by a small margin during the quarter, but growth remains well ahead of value year-to-date with the Russell 3000 Growth up +23.77% vs. +1.67% for the Russell 3000 Value.
As highlighted by the spread between growth and value, the equity market’s resilience has not been evenly distributed.
Considerable attention has been devoted to the renowned “Magnificent 7.”¹ While most of these stalwarts declined during Q3, the majority of the market’s overall return year-to-date has been driven by these few Large Cap stocks. Looking at the 10 largest stocks in the S&P 500, with the exception of one stock, all are currently trading at a valuation exceeding 20x forward earnings. This raises questions about the sustainability of the current market trend of outperformance by these few Mega Cap names as the S&P 500 Equal Weight Index trades at a much lower 15.4x earnings.
In terms of sectors, Energy stocks exhibited exceptional performance during the quarter, led by the surge in oil prices resulting from prolonged supply reductions implemented by OPEC and Russia. While rising oil prices reflect a recovering market that was hit hard during the pandemic, economists have expressed concerns about the potential consequences for consumer behavior. Prolonged periods of high oil prices can translate into increased costs for businesses and consumers alike. Consequently, cautious consumer behavior may arise as individuals grapple with the financial strain posed by elevated fuel prices.
During the quarter, we observed a continuation of the trend where Domestic Small Cap and International shares lagged U.S. Large Cap. The Russell 2000 experienced a decline of -5.13%, while the MSCI EAFE saw a decrease of -4.11%. One potential silver lining amidst this ongoing underperformance is the opportunity to acquire equities at more attractive valuations in both market segments. Although short-term valuation reversions are unpredictable, a more affordable initial investment should positively impact long-term future returns…
Continue reading by downloading the full report HERE which includes exhibits and sections that discuss:
- Bond Yields Keep Rising
- China’s Property Sector Fallout
- Market Index Review – September 2023
- U.S. Economy Surprises to Upside Despite Fed Hikes Rates
- Q3 2023 U.S. GDP Estimate
- Number of U.S. Job Openings
- Number of Layoffs
- Maybe a Recession isn’t a Foregone Conclusion
- Equity Market Breadth Still Lagging Despite Strong Returns
- S&P 500 Performance vs. Breadth
- Valuations Slightly More Useful as Long-term Predictor
- Is Recent Performance Dispersion Driven by Cost of Capital?
- Investors Swing Between Optimism & Caution
- Bond Yields and Fed Funds Futures Diverge
- Where Do Bonds Go From Here?
- Fixed Income is More Than Just Interest Rates
- Risks: Rising Oil Prices
- Risks: A Slowing China
- Approaching the 2024 Presidential Election
Sources in the report:
- Atlanta Federal Reserve Bank
- Bureau of Economic Analysis
- Bureau of Labor Statistics
- Wall Street Journal
- Goldman Sachs
- Charles Schwab
- Bespoke Investment Group
- Standard & Poor’s
- U.S. Energy Information Administration
- CME Group
- International Energy Agency