Equities pulled back in the third quarter after a first half of the year that was good to great for most major equity indices. The information technology and consumer discretionary sectors were two of the three best performing sectors in the first half of the year, but they lagged the S&P 500 in the third quarter. On the other hand, the communications services sector was the second best performing sector in the third quarter and ended up 2.84% for the quarter and 39.43% through the first nine months of the year. The energy sector recovered and was the best performing sector last quarter as higher energy prices pushed energy stocks higher. The worst performing sectors for the quarter and year-to-date were the utility, real estate, and consumer staples sectors, three sectors that are often perceived to be “safer” and less volatile. Whether it was investors looking for yield migrating back to bonds, poor balance sheets, or other idiosyncratic issues, these sectors were clearly out of favor.
Small and midcap stocks gave up most of their first half gains. Rising interest rates adversely affect smaller companies, while the varied sector exposure compared to the S&P 500 adversely affected their relative performance. Nevertheless, the S&P Midcap 400 and Russell 2000 are still up 2.95% and 1.35%, respectively, year-to-date. International equity performance varied. The MSCI EAFE Index is up a respectable 4.49% year-to-date, despite having very few tech companies in the index. The MSCI Emerging Markets Index is down 0.38% through September, but most of the weakness was attributable to its large China weighting. The MSCI Emerging Markets ex China Index ended up 6.20% through September in spite of the 3.33% decline in the quarter.
Bond investors also lost money in the third quarter. The Bloomberg Intermediate US Govt/Credit Index was down 0.83% for the quarter while the Bloomberg Aggregate Index (“the Agg”) lost 3.23%. Rising bond yields reduced the total return for the Bloomberg Intermediate US Govt/Credit Index to 0.65%, while the Agg was down 1.21% in the first nine months of the year.
Gold also lost ground in the third quarter. It dropped 3.68%, but is still up 1.35% through September. The U.S. Dollar Index defied naysayers and rose 3.17% during the quarter to end the nine months 2.56% higher. Oil prices erased their first half losses and are now up 13.12% for the nine months ended September 30th. OPEC+ reductions and better-than-expected economic growth contributed to a 28.52% rise in oil prices during the third quarter. Sometimes oil prices are an indicator of rising inflationary pressure throughout the economy. That has not been the case this year. Despite its large energy weighting, the CRB BLS Commodity Index, is down 1.04% year-to-date. Key food prices such as corn, wheat, and soybeans are down double digits year-to-date, while copper, lithium and lumber prices have also dropped. As opposed to 2021 and 2022 when rising oil prices were symptomatic of broad inflationary pressures, NPP believes the current price increases are distinctive to the energy market. Nevertheless, oil prices have huge economic ramifications and the trend bears watching.
Crosscurrents for Equities
Sell in May and go away is one of the best-known market mottos. It captures the historical pattern of the best returns for equities generally occurring from November to May. The rest of the year produces positive but lower returns on average. That has been the case so far in 2023. NPP thinks things are looking up for the fourth quarter. Earnings reports will begin mid-October. Expectations were high last quarter, and earnings could not help but disappoint even when they were solid. Now we think the reverse is true. Investors are cautious on profit potential even though the economy remains strong. Some of the froth has been wrung out of the technology leaders. Several of them have pulled back to reasonable, but not cheap levels assuming earnings hold up.
This does not mean that all is clear for equity holders. We still think investors would do well to avoid highly levered companies and corporations that have significant maturing and variable debt. Bond maturities will have to be refinanced at much higher levels. We still think investors should focus on companies with pricing power that benefit from significant economies of scale, whether or not they are technology companies. We expect equities to produce positive returns in the fourth quarter.
Bond Yields Continue to Rise
The Agg was down in 2021 and 2022, the first time in the history of the index that it fell two calendar years in a row. Agg investors are on pace to lose money for the third year in a row with the index down 1.21% through September. Longer term and intermediate bonds have not provided positive returns, and they have not always provided diversification as opposed to the past few decades. In 2022, they fell in tandem with equities. This does not mean balanced investors should avoid bonds. NPP believes intermediate bonds provide some protection and diversification against equities. Additionally, the rise in yields is unlikely to be as dramatic as it has been since yields started rising in 2020. Moreover, high-quality fixed income investments now provide something they have not in a while, income in excess of inflation.
It is not all smooth sailing for fixed income investors. The neutral rate has probably shifted higher from the post-GFC period. U.S. budget deficits are rising. Additionally, the surprisingly strong U.S. economy has led to higher growth rates and accordingly higher interest rates. The initial rise in interest rates was due primarily to higher inflation. The recent rise is the result of higher growth expectations in the face of moderating inflation data.
Government Shutdown Averted at Last Minute
Another government shutdown was avoided at the last minute when the House of Representatives and the Senate reached a last-minute deal. This is not the end of the issue, but allows the government to continue operating for forty-five days. We do not want to gloss over the problems shutdowns cause or minimize the unfortunate impact on government employees. Nevertheless, they do not hold the potential for economic damage that a debt default does. NPP does not think the overriding concern is that the government will shut down for an extended period of time at some point. Instead, we worry that there is a minor risk that constant brinksmanship could lead to higher government borrowing costs in an era of rising deficits.
Economy Growth Remains Solid
The U.S. economy has withstood various economic headwinds and a drop in consumer confidence. It has managed to grow at a respectable pace while inflation moderated. We think this trend remains in place in the fourth quarter. In contrast to many other economies, our economy is service-driven and net energy independent. Moreover, the United States retains its reserve currency status. It is significantly more resilient than many investors and economists have given it credit for. The tight labor markets make it harder for the economy to slip into recession.
Several risks are on the horizon and have been discussed frequently in the press. In addition to the government shutdown, these risks include auto strikes, higher interest rates, student loan payments restarting, and the end of federal aid to childcare providers. We do not think any of these risks individually or in aggregate are enough to tip the United States into recession. Admittedly, it is futile forecasting what can go wrong. Frequently, it is something that is unexpected that tips the United States into recession. In the middle of 2019, the risk of recession was slightly elevated, but nobody expected a virus to level the global economy.
Fourth Quarter Outlook
We are close to the end of the worst seasonal part of the year and approaching the best months of the year for equities. Markets and large-cap technology stocks were due for a pause after a strong first half. The recent pullback has reduced equity multiples. As always, earnings and outlooks will be hugely important when companies start releasing their third quarter reports in mid-year. We think reasonable valuations coupled with a low bar will lead to a solid quarter for equities. Moreover, companies will be able to resume repurchasing their own stocks once their reports are released. Bond investing has been difficult over the last three years or so, but investors should do better in the future given the higher starting point for yields. There are economic risks on the horizon, but NPP thinks they are more likely to lead to a slowdown and not a recession in the near-term. In short, investment opportunities appear attractive, but there is no reason to take excessive risks.