After rallying through July, equity markets displayed their characteristic late summer turbulence this year as stocks turned south in August and September. Additionally, Investors have found little solace in fixed income as rising oil prices and a resilient jobs market reignited inflation fears, driving yields higher and bond prices lower.
Entering the summer months, investors appeared confident that the US economy could avoid recession, while the Fed was seemingly near the end of its rate hiking cycle. Bullish sentiment pushed the S&P 500 up 20.6% through July, within shouting distance of all-time highs set last year. Market breadth, however, remained elusive with only seven mega-cap growth stocks bolstered by the Artificial Intelligence theme contributing most of the equity returns.
As the quarter ended in September, the bullish sentiment that lifted stocks to near-record highs in July seems to have faded. While recent data suggests the economy is on solid footing, the belief that the Fed was done hiking and would soon begin cutting interest rates now appears unlikely. With growth data of almost every variety surprising to the upside, good news on the economy, once a tailwind supporting bullish sentiment, turned into a headwind in September as a “hawkish” Federal Reserve spoke of keeping interest rates “higher for longer.” As Fed Chair Powell noted in the September FOMC press conference, “if the economy comes in stronger than expected, that just means we will have to do more in terms of monetary policy to get back to 2% inflation.” Notably, the Atlanta Fed’s GDP “Nowcast” for Q3 is running north of 5%, considerably higher than consensus forecasts.
Despite the heightened anxiety experienced in August and September, the S&P 500 ended the quarter with a relatively modest decline of only 3.2%, marking the smallest quarterly movement in nearly two years. While the previously high performing Magnificent Seven stocks (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, Tesla) lost momentum, energy stocks rallied impressively by 13% during the quarter, largely due to oil prices surpassing $90 per barrel. Additionally, dividend stocks, which had underperformed in the first half of the year, made a strong comeback, outperforming for the first time since late 2022.
As we enter the fourth quarter, we are seeing an apparent shift in market sentiment. As we discussed in our July commentary, it is generally healthier for a broader range of stocks to drive the market’s returns rather than relying on only a select few. Through September, the Magnificent Seven had contributed 126% of the S&P 500’s total return, indicating that the remaining ~493 stocks in the index had collectively underperformed for the year. The Magnificent Seven and other high-growth stocks are often categorized as “long in duration,” meaning most of their earnings will come in future years, thus leaving them more sensitive to rising or higher interest rates. With the prospect of rates staying “higher for longer” there is potential for broadening equity participation in the upcoming quarters, encompassing various sectors of the economy.
Looking ahead, we anticipate continued strength in energy-related equities, supported by improved margins and increasing global demand for oil amid supply constraints. The Industrial sector, with historically low balance sheet leverage, attractive dividend yields, and cyclical tailwinds, also appears promising. Additionally, we anticipate intriguing opportunities within the Technology sector, particularly in companies with ties to the AI theme that are trading at valuation discounts compared to sector averages.
While the dual risks of inflation and higher interest rates have been under the market microscope for over a year, it’s important to acknowledge two emerging risks that have recently caught the attention of investors. Despite the horrific news coming out of the Middle East, the market’s reaction to the conflict has been relatively calm though Tuesday, October 10th. While we acknowledge and mourn the immeasurable human suffering of the current conflict, historically, geopolitical events related to Israel have shown limited impact on U.S. and International stock markets.
The major market-related risk that we see is the potential for the conflict to escalate to the point where already fragile Saudi-Israeli relations deteriorate further leading to additional Saudi oil production cuts amid already tight global supply. Any additional production cuts would send oil prices sharply higher, placing the U.S. economy at risk. While this is not a base case assumption, we remain mindful of the possibility.
Source: Charles Schwab, FactSet data as of 10/9/2023.
Daily data for the MSCI EAFE Index is not available prior to 1/1/1980.
The market has also seemingly shrugged off the recent ouster of U.S. House Speaker Kevin McCarthy. The principal obstacle the House faces now is electing a new Speaker prior to the expiration of the Continuing Resolution (which has kept the Government open) on November 17th. The ongoing process to elect a new Speaker will delay work on the budget, potentially leaving Congress with the choice of passing another Continuation or shutting down the government. Despite the unprecedented nature of the event and small near-term risk of a government shut down, we view this as an immaterial risk to long-term investors.
While we remain optimistic on equities for the fourth quarter, we continue to keep a watchful eye on recent developments that could affect client portfolios.