The LTWM Insider – Market and Economic Commentary Q3 2023
Executive Summary
If the Federal Reserve Board handles the spike in yields resulting from the current lack of buyers in the U.S. Treasury bond market, which we believe it will, we remain cautiously optimistic on the strength of the American consumer, since jobs are still plentiful, and workers are proving to be very resourceful in the face of high inflation.
There are challenges in many places that could represent a black swan event, and now we are all witnessing a second overseas conflict in the Middle East with Israel declaring war. Stocks are holding up much better than anticipated, going from red to green on the first day markets were open. The rally may be due to the breathing room it gives the Fed to move from raising rates to holding rates steady.
Plenty of macroeconomic data exists to support either the bull or bear view for the last quarter of the year. The third quarter was negative for stocks and bonds, following two quarters of positive stock returns in 2023. The last stock market record high was January 5th, 2022; and stocks are currently below that level, but well above the low of October 2022. The bull market view is supported by the continued strength of the U.S. job market and when jobs are plentiful, U.S. consumer spending drives GDP and corporate earnings growth higher. The opposing view suggests that the bear market from 2022 has yet to conclude; and it foresees a looming recession as the likely outcome of the current level of very high interest rates aimed at reducing inflation back to 2%. The supply/demand balance of owning stocks appears neutral, but the bond market is out of balance with way more sellers than buyers; and that situation has caused a great deal of concern for stocks in the past quarter. A change in language by the Fed could cause a sharp reversal in longer term U.S. Treasury yields, which have climbed much higher than any forecast a short while ago.
We are cautious due to the uncertainty and are maintaining a higher than normal level of portfolio cash; but remain optimistic about the prospects for normalized interest rates, continued economic and corporate earnings growth, and improved productivity from new technologies. We want to remind you we are watching all the developments closely and look forward to meeting with you soon.
For those who would like a deeper dive into the details, please continue reading…
World Asset Class 3rd Quarter 2023 Index Returns
The third quarter was negative for all asset classes and especially for real estate, given the asset’s class interest rate sensitivity. All broad equity asset classes were negative in the third quarter, along with global and U.S. bonds, after two quarter of positive returns this year. For the broad U.S. Stock Market, the third quarter return of -3.25% was well below the average quarterly return of 2.2% since January 2001. International Developed Stocks returned -4.10%, also well behind the long-term average quarterly return of 1.5%. Emerging Market Stocks returned -2.93%, well below the average quarterly return of 2.4%. Global Real Estate Stocks returned -6.49%, well below the asset class’s average quarterly return of 2.1%. The rapid rise in bond yields during the quarter was unexpected and had a negative impact on all asset classes.
Here is a look at broad asset class returns over the past year and longer time periods (annualized):
For the past year, International Developed stocks led all broad categories with a positive return of 24.0%, U.S. stocks were close behind, up 20.46%, while Emerging Markets stocks were up 11.7% and Global Real Estate stocks were up 2.03%. The U.S. Bond Market gained 0.64% and Global Bonds were up 2.99% for the past year. Over the past five years, U.S. stocks were up 9.14% annually, while International Developed stocks were up 3.44% annually, Emerging Market stocks were up 0.55% annually, and Global Real Estate stocks were basically flat at 0.01% annually. The U.S. Bond Market was up 0.1% annually for the past five years, while Global Bonds were up 0.83% annually. Over the past 10 years, the U.S. stock market (up 11.28% annually) is well ahead of International Developed (up 3.84% annually) and Emerging Markets (EM) stocks, which are up only 2.07% annually over the past 10 years; Real Estate stocks are up 3.12% annually, US Bonds are up 1.13% and Global Bonds are up 2.3% annually.
Taking a closer look within U.S. stocks during the third quarter, some asset classes were down more than others. At the top, is Small Cap Value, which was down the least (-2.96%), while Large Growth, Large Cap Blend and Large Cap Value were all about 15-20 bps lower and near Marketwide results of -3.25%. The hype around AI tech stocks flattened out during the third quarter. The regional banking index has yet to recover, as higher interest rates remain a concern for banks. Small cap growth stocks tend to sell off when a recession nears.
So far, there is no evidence of a systemic banking concern, including commercial real estate loans. We believe almost all banks will make it through a period of higher default rates as lenders and borrowers negotiate new loans. The uncertain future weighs on small cap stocks, since large cap stocks are considered more defensive during challenging economic times. The Fed is receiving help from higher bond yields in its attempt to slow the economy to bring inflation back to its 2% target. Higher interest rates, including auto loans and mortgages reduces the demand for large ticket price assets.
If we extend our analysis of U.S. stocks over longer time periods, Large Growth stocks lead over the past year, 27.72% vs. 14.44% for Large Value. However, Large Value is ahead of Large Growth over three years, 11.05% annually vs. 7.97% annually while Small Value stocks are ahead of both over the past three years, up 13.32%. Large Growth is the top returning asset class over the past 5 and 10 years. It is worth noting that U.S. Market wide results for the past 10 years remain very strong, up 11.28% annually.
The U.S. business cycle continues to slow by many measures, and leading economic indicators have slowed every month for the past 20 months, which could place the economy in recession at some point this year or early next year. The American consumer is displaying signs of strain, spending is up in nominal terms, but down in real terms (after adjusting for inflation). The average wage earner is holding up because of a second job. Payroll jobs are up much more than household surveys (payrolls double count those with more than one job). However, claims for unemployment insurance are down from the second quarter, which means the U.S. job market remains very tight; and until it falters, we are not likely to experience a recession in the near term.
The Fed has paused from hiking rates but continues to sell Treasuries and mortgages at a monthly pace of just under $100 billion, which has a similar effect as a rate cut every few months. Higher interest rates in the U.S. create more demand for the U.S. dollar, which has appreciated against most foreign currencies. Japan’s central bank continues a strategy of Yield Curve Control (YCC) by purchasing bonds at all maturities and anchoring the short end of the curve near zero. The Japanese Yen has depreciated significant against the U.S. dollar.
International Developed Value Stocks were up in local currency, but up way less in U.S. dollars, since the dollar appreciated against most foreign currencies during the third quarter. The Euro went from $1.08 to its current value of $1.05. It is way down from $1.18 two years ago. The currency effect served as a near 3% headwind to international stock returns during the quarter. The value premium (Value-Growth) was very positive (0.19% vs. -8,24%), and the size premium was slightly positive (Small Cap-Large Cap, -3.48% vs. -4.1%). Our investment funds are priced in U.S. dollars (unhedged) and benefit from a weakening dollar and lose value with an appreciating dollar:
Over longer time periods, the value premium (value-growth) is positive over the past 1 and 3-year period, but still negative for 5 and 10 years. The size factor premium (small cap-large cap) is positive in the past quarter, negative in the YTD, 1-year, 3-year and 5-year periods and positive over the past 10 years.
Moving the commentary to fixed income, bond market returns around the world were negative during the third quarter, as yields increased for most bond maturities. The bond market is no longer predicting any more interest rate increases by the Federal Reserve, but the Fed’s QT (quantitative tightening) program of selling $90-100 billion of bonds per month is expected to continue for many years. The yield on the 5-year Treasury note increased by 47 basis points, ending the quarter at a yield of 4.6%. The yield on the 10-year Treasury note increased by 78 basis points, ending the quarter at a yield of 4.59%. And the 30-year Treasury bond yield increased by 88 bps to 4.73%. Here is the U.S. yield curve, and you can see how yields increased significantly for all maturities longer than 2 years (current yield curve in grey, one quarter ago in blue, and one year ago in green):
Looking at fixed income asset classes, the highest third quarter bond return is for the U.S. 3-Month Treasury Bill Index, up 1.31%, while the One-Year Treasury Note Index was up 1.21%. At the bottom end for Q3, the U.S. Government Bond Index Long (long-term Treasuries), was down an amazing -11.77%, and it now down -15.66% annually for the past three years. The Aggregate Bond Index is down -5.21% over the past three years. Both resemble equity-like returns. Beware of the losses that can result from holding longer maturity bonds in an interest rate rising environment. Here are the fixed income period returns:
During the third quarter, the U.S. fixed income markets were impacted by much more than a hawkish Fed to send yields up and bond prices down. The Fed continues its $8 trillion balance sheet reduction (selling bonds) at a rate of ~$95 billion per month or $1.1 trillion annually. The sharp rise in long-term yields resulted from many other factors reducing the supply of bonds and limiting demand. Other central banks around the world are reducing their dollar denominated holdings as they use other currencies in trade and finance; and no longer require large holdings of U.S. Treasuries. Primary Treasury bond issuance by the U.S. Treasury is very high due to the large deficit spending of the government, increasing the number of Treasuries for sale. Hedge funds are taking advantage of the supply-demand imbalance by shorting the ETF that tracks the 10-year Treasury (TLT), which has become a very crowded trade. The result is more sellers and fewer buyers.
The Fed will only lower rates when jobs look to be in trouble. Historically, stocks start a long decline after the first Fed rate drop. However, stocks can continue up with a long pause by the Fed if the supply-demand imbalance in the Treasury market normalizes. At any time, the Fed could take action to stop the rapid rise in yields by simply speaking more dovish or by threatening to lower rates, due to an external conflict like war in the Middle East.
The final read of U.S. GDP for the first quarter of 2023 was up substantially (2%) from the second read of GDP for the first quarter at 1.3% (1st estimate was 1.1%). GDP growth came in at an annual increase of 2.6% in the fourth quarter (final read after 2.9% initial). Real GDP growth for 2022 (full year) was 2.1% and is now expected to slow to 2.0% in 2023 and 0.8% in 2024. Much stronger GDP growth numbers than the estimates from the beginning of 2023.
One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.
CONCLUSION
The unexpected jump in bond yields during the last quarter caused stocks to have negative returns. The new conflict in the Middle East is likely to keep the Fed from another rate hike. Rates may remain higher for longer, which is the new Fed mantra, but change in language is all that is needed to bring down Treasury yields.. The inflation outlook is improving slowly. The labor market is starting to show cracks, consumers are more cautious with spending, and so far, major companies are not letting go of workers or if they are, new job openings are plentiful.
Our recommendation, as always, is to tune out the news and focus on what you can control with your financial well-being. Please reach out to us with any questions or concerns. We are here to help you succeed and look forward to seeing you soon.
Here is an important piece from our friends at Dimensional, reminding us about the power of value stocks:
The first half of 2023 marks the tenth time since 1926 that value stocks have underperformed growth stocks by more than 20 percentage points over a two-quarter period. More often than not, value has responded like the hero in an action movie, beating growth over the following four quarters in seven of the nine previous instances and averaging a cumulative outperformance of nearly 29 percentage points.
The sample size may be small, but a positive average value premium following a large negative period is not too surprising. In fact, looking at the other side of the value performance distribution, there have been 19 two-quarter periods with the value premium exceeding positive 20%. In 11 of these, value outperformance continued over the next four quarters. The average premium across all 19 was 3.6%.
It’s notoriously challenging to find an indicator that consistently predicts negative value premiums. Regardless of value’s recent performance, investors should expect positive value premiums going forward. That’s a strong incentive for investors to maintain a disciplined stance to asset allocation, so they can capture the outperformance when value stocks deliver.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2022, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2022, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2022 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2022 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.
