Economic growth remained resilient despite market consensus and continued fear of an imminent recession.
Long term interest rates ticked substantially higher over the quarter as the Federal Reserve maintained its tighter monetary policy, wider deficits, and higher nominal growth expectations. Interest rates stay “higher for longer”.
Equity market performance was rangebound in the quarter while the “Magnificent 7” large capitalization growth stocks that led broad market performance over the first half of the year showed signs of stalling.
Equity Market Overview
Third quarter equity market performance remained challenged as investors digested conflicting fundamentals including substantially higher interest rates and corporate borrowing costs, a rather resilient economy, rising commodity prices, and softening artificial intelligence euphoria. Divergences in equity valuations are at, or nearing, extremes. The large cap technology names driven more recently by their moves into artificial intelligence (AI) commanded earnings yields less than that of risk-free U.S. Treasuries on hopes of the Federal Reserve easing monetary policy in 2024. Whereas, valuations in the more cyclical parts of the market, such as small capitalizations stocks, are at Global Financial Crisis lows.
Equity valuations currently imply rather puzzling assumptions related to future economic and profit growth. On one hand, a select handful of large cap U.S. growth companies dubbed the “Magnificent 7” (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, Tesla), that powered the S&P 500 index higher from January through August currently trade at valuations that suggest a “no-landing” economy and immense profit growth powered by AI.
However, the majority of equities (with certain exceptions) trade at valuations that infer an imminent and dire economic “hard-landing”. Most non-“Magnificent 7” companies today, including those with strong balance sheets, may even have solvency issues should this scenario play out. This group of stocks are the remaining S&P 500 index’s 493 companies.
We strongly believe that many investors are making a substantial mistake today - banking on future economic growth turning out so poor that only the Magnificent 7 companies, which are primarily concentrated in the information technology and communication services sectors, will be able to generate future profit growth! While you can call it skeptical, we believe this is an unrealistic scenario and that many market participants today are putting far too much faith in the same select few companies that outperformed in the prior bull market of the 2010’s and leading in 2023. Many investors today are assigning a high likelihood of a return to future mega-capitalization company dominance by placing very outsized portfolio allocation weightings to these select few behemoth companies.
We believe investors chasing the previous market leaders higher in 2023 have conveniently forgotten about the stock market carnage that played out in 2022. In our view, equity diversification is more critical than ever given the extreme spreads in relative market valuations and investor sentiment, coupled with a secular shift from deflation to inflation. Historically, the largest and most popular companies that investors grow to adore over a bull market cycle tend to underperform the S&P 500 index over the future decade.
Extremes in market sentiment tend to eventually present strong investment opportunities, and we believe the leaders of the remaining years in the 2020’s will look far different than those of the last decade. Accordingly, we are well positioned today to take advantage of an expected market dislocation and reversion to the historical mean.
Case in point, we can look to small capitalization companies that are far less substantial in size relative to the Magnificent 7 and other S&P 500 index companies. Small cap stocks represented by the S&P 600 index are DOWN roughly 0.5% year-to-date, whereas large cap stocks represented by the S&P 500 index are UP roughly 12.1% year-to-date. The last time small cap stocks underperformed large caps by such a substantial margin was in 1998. However, the subsequent 5 years after 1998 painted a different picture with small caps outperforming large caps by a long shot in that period. This type of phenomenon has taken place routinely and repeatedly throughout history.
Fixed Income Market Overview
Global interest rates moved substantially higher in the third quarter for a variety of factors:
Central banks hiking their benchmark rate targets and signaling their intent to keep monetary policy tighter for longer
Accelerating fiscal deficits in Western governments (such as the U.S.)
Higher nominal economic growth expectations due to higher expected future capital expenditures and inflation.
We’re expecting inflation rates to remain elevated over the coming years (or more) relative to the 2.37% inflation rate currently implied by the bond market. Should inflation remain higher, central banks may have no choice but to keep rates higher in an effort to keep inflation contained. However, the U.S. government currently has an unsustainably high ratio of total debt to GDP. This eventually becomes unsustainably expensive for the government in high inflation environments like today where a growing portion of the total debt is being issued at a far higher cost to the government (i.e. higher interest rates).
Should inflation remain higher for an extended period, our take is that the U.S., as well as other governments, will eventually need to monetize their debts (i.e. treasury bonds) to lower their total debt to GDP ratio by way of printing new money to pay their treasury bond debt-service with inflated dollars. If this type of scenario were end up playing out over the longer-term, it will be a double-edged sword for consumers as interest rates would remain high to continue taming inflation, all while printing new money to lower the total debt to GDP ratio is a tactic that would actually drive inflation higher, all-else-equal. In this case, tax rates would also be likely to remain higher to allow governments to finance the deficits.
Because of this, our fixed income preference today is towards shorter-term issues (< 1-year – 2-year maturities) and more particularly, generally avoiding longer-term “risk free” treasury bonds.
Economic Outlook
Six weeks after the United States invaded Iraq in early 2003 with the intent of toppling the Hussein regime and the alleged threat of weapons of mass destruction, President George W. Bush gave his infamous “Mission Accomplished” speech. In the prepared text, the former President stated “Major combat operations in Iraq have ended. In the battle of Iraq, the United States and our allies have prevailed…the regime is no more.”
The optics strongly suggested combat goals had been accomplished and victory declared. However, with no detest towards the former President, 104 Americans ended up losing their lives in the Iraq war prior to the Mission Accomplished speech and the war raged on another eight years until 2011, with an additional 3,425 Americans and countless Iraqi and coalition forces tragically losing their lives.
While the Bush administration eliminated the Hussein regime, the larger threat of counterinsurgency was underestimated. Consider this a prime example of the risk of declaring false victory. We see a similar threat of claiming false victory today, albeit in a financial and not war sense, in that both market participants and the Federal Reserve are placing strong conviction in the belief that inflation will reach the Federal Reserve’s 2% inflation target in the foreseeable future.
Investors, and policy makers alike, tend to extrapolate near-term conditions when projecting out what the unknowable future may look like. In behavioral finance, this is called recency bias. Despite the convenience of inflation falling in a straight line from 9.0% to near 2.5% in just over one year’s time, we caution investors to resist the urge to display the Mission Accomplished banner just yet.
Historically, inflation has reared its head in longer-term waves as supply and demand imbalances, paired with monetary policy responses and human psychology, have led to price and market volatility. We view the 1970’s as a prime example of this phenomenon that we could be in the midst of today.
According to research from Research Affiliates, when looking at 14 countries where inflation peaked at approximately 8%, it typically took over 4 years for inflation to be brought back below 2%! While it is certainly possible the Fed’s inflation target is reached in the near-term, we deem this risk to be present for several years as structural inflation continues to run its course throughout the intricacies of the economy.
Conclusion
As we enter the final quarter of 2023, diversification sits at the cornerstone of our investment portfolio allocation framework. Our client's portfolios are positioned defensively amid the broad expectation of inflation and interest rates staying “higher for longer” and for an expected secular dislocation of the performance leaders of the last decade to be different over the remaining years of the roaring 2020’s. As a reminder, the top performing stocks and sectors over historical decades and bull markets have in most cases tended to underperform the S&P 500 index over the future decade.
While we expect that the foreseeable future may be a bumpy ride entailing a slew of corrections and mean reversions, we are committed to helping our clients stay on track to achieve their long-term financial goals.
Disclosure
*RISE Investment Management, LLC ("RISE" or "RISE Investments") is an investment adviser registered under the Investment Advisers Act of 1940. Registration of an investment adviser does not imply any level of skill or training. This publication is solely for informational purposes and past performance is not indicative of future results. Any historical returns, expected returns, or projections are provided for informational purposes only. The description of products, services, and performance results of RISE contained in this publication are not an offering or a solicitation of any kind. No advice may be rendered by RISE Investments unless a client service agreement is in place. Advisory services are only offered to clients or prospective clients where RISE Investments and its representatives are properly licensed or exempt from licensure. All of the information in this publication is believed to be accurate and correct as the date set forth. RISE does not have or accept responsibility or an obligation to update such information.