Q3 Market Musings: Interest Rates, Outlooks and Opportunities

The rumors and rumblings of the US economy spiraling into a recession seem to have been somewhat exaggerated.  It was no less than 6 months ago that several prominent economists’ base case was for negative GDP as we move closer to and into 2024.  The future does not appear that draconian, but the confluence of a prolonged inverted yield curve, multiple interest rate hikes, inflated overall prices and tight labor markets have collectively shaped the consensus view of a slower growth economic environment is the future.  Although we believe there remains risk of a recession over the next several quarters, base cases are being adjusted and the notion of a soft landing is starting to seem more realistic (controlling inflation without inducing negative growth).

Whether we face a “soft landing” or “hard landing,” the Fed and inflation remain the dominant story line.  Certain core questions continue to be asked. How much further can and will the Fed raise rates if inflation proves persistent?  Will the cost of money and borrowing ultimately upend the consumer? (30-year mortgage rates recently reached 7%.)  Perhaps surprisingly so, the consumer has remained strong and a key contributor throughout this cycle.  While careful not to prognosticate too precisely about the future or Fed policy direction, we do feel, as we survey the current landscape and data points, that we are moving closer to a Fed pause.  Going a step further, we are likely within a year of the Fed cutting rates (quantitative easing).  Given this backdrop, we feel certain assets classes may benefit from these changes.

Bonds, or fixed income, look attractive nearer-term.  Bonds have come off their worst year (2022) since the industry has been tracking bond performance.  It should come as no surprise that the Fed’s efforts to raise rates from virtually zero to over 5% lead to this underperformance.  Historically speaking, bonds perform well in flat and declining interest rate environments – a backdrop that we are likely starting to approach.  There is a lot less interest rate risk currently then there was just 13 – 15 months ago.  Further, improved bond income can offset some of the pricing risk if the Fed decides to raise rates a little more.  Thus, our outlook for bonds is more positive at this time.

Equity-wise, we also recognize the accretive nature of quantitative easing.  And although we still believe we are 9-12 months away from the Fed cutting rates, we remain constructive that we will eventually transition to a bull market and into an expansionary phase.  Return attribution has clearly favored growth stocks.  A group of stocks referred to as the “Magnificent Seven” (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms) have been primary drivers of stock market returns – thanks, in large part, to the enthusiasm surrounding AI/Artificial Intelligence.  These seven stocks (plus) have not only driven the S&P 500 up over 18% year-to-date (“YTD”), but has propelled the Russell 1000 Growth Index up over 30% this year.  Interestingly, last year’s best performers (value stocks) are only up a little over 6% YTD.

Given the level of appreciation experienced by growth stocks, we expect some profit-taking to occur.  Declines are also expected after markets increase along these lines.  We would view any pullback of substance as an opportunity to thoughtfully add to the equity markets as we are mostly positive on stocks long-term.  Staying diversified and even increasing exposure to fixed income seems prudent at this juncture.  As always, please reach out to us if you have any questions or would like to discuss any of these thoughts and comments in more detail.