Rising Headwinds Present New Opportunities
The third quarter of 2023 saw the reacceleration of several key underlying economic themes. The sharp rise in the oil price reflected the favorable dynamics at play in the energy industry and the increase in long dated treasury yields to 16-year highs bolstered the “higher for longer“ view for the interest rate cycle. These developments also drove an increase in the strength of the US Dollar. The triple-play of higher rates, higher oil prices and a stronger currency are evidence of tightening conditions across the economy that collectively present significant headwinds.
The markets responded with weak performance throughout the period as most equity and fixed income indexes were down in the low to mid-single digits. In contrast, we believe our portfolios performed quite well with several strategies showing modest positive gains. Key portfolio highlights for the quarter were the following: 1) our energy position showed strong price appreciation 2) our cash and short-term positioning in treasuries shielded client portfolios from the pressures of rising interest rates; and 3) our overall underweight to equities protected portfolios from downside volatility.
Misleading Market Performance
Narrow leadership of the stock market has been a continuous topic throughout 2023. The S&P 500 showed a double digit return through the first nine months of the year with nearly all performance attributable to just 7 stocks. As shown in Chart 1, the S&P 500 Equal Weight Index was only slightly positive through the end of the quarter. The difference between the capitalization weighted S&P 500 and the Equal Weight index was almost completely explained by the anomalous performance of “The Magnificent Seven”.
The influence of these seven names presents a misleading and distorted view of market performance and the opportunities in U.S. equities. Additional perspective is gained when viewing price movements in a medium-term context (see Chart 2). Since the beginning of 2022, stocks, as measured by the Equal Weight Index, have declined by approximately 10%. In fact, the performance of “The Magnificent Seven” was so weak during 2022 that the impressive run thus far in 2023 has only managed to bring those stocks to break even levels for the trailing 7 quarters. Further, these stocks appear to be more expensive today than they were just before their prices corrected in 2022.
The highlight has been energy stocks, which have occupied a meaningful part of our portfolios and have outperformed both “The Magnificent Seven” and the average stock by wide margins. Even after such strong performance, we believe these stocks remain attractively priced and continue to possess attractive fundamentals. They represent a great example of our practice of focusing portfolios on the most compelling returns with high margins of safety.
Growing List of Concerns Offset Resilient Economy
The economy has proven to be quite resilient in the face of mounting headwinds over the last several quarters. While employment and personal consumption have remained strong, leading economic indicators have now been weakening for over 17 straight months, lending standards have tightened to levels consistent with previous recessions and the 10-year yield has risen by over 150 basis points since the lows in March as depicted in Chart 3.
The sharp increase in long-term interest rates has contributed mightily to the recent tightening of financial conditions. A higher rate environment translates to an increased burden of debt service costs, increases the likelihood of additional financial sector instability, and raises the cost of capital for new capital investments. It also creates additional budget stress for the consumer, who is already displaying early signs of weakness through rising credit card delinquencies and the resumption of student loan payments. These factors present significant headwinds for future growth.
Higher rates also impact the discount rates investors utilize to value risk assets. Eventually, the higher for longer rate environment should impact valuations for equities and real estate and the corresponding prices of risk assets are likely to suffer accordingly.
Government Now Under Pressure
Fiscal policy has supported the financial markets tremendously since the COVID crisis, yet the rising cost of financing for incremental expenditures and the increase in the future interest burden on existing debt is almost certain to transition fiscal support from a tailwind into a headwind.
The Federal Reserve may have paused from hiking the Fed Funds Rate in September, but the bond market has pushed long dated treasury yields higher. Given the size of government obligations, the embedded future increase in debt service impedes the capacity for fiscal support and it presents major challenges for policymakers.
The Return of Fixed Income
The abrupt change in the interest rate backdrop has clearly brought a number of risks to the surface, but there is more than just a silver lining to discuss with respect to future investment opportunities. In previous editions of the Capital Markets Review, we have highlighted the emergence of a “New Era”, and we have also explored the importance of “Staying on Schedule” to meet long-term objectives for client portfolios. The return of fixed income is emblematic for both themes.
For much of the past 15 years, opportunities in fixed income have offered far more risk than reward. As Chart 3 demonstrates, the 10-Year Treasury yield has broken out of its long-term downtrend and now offers the highest rate it has since 2007. Other areas of fixed income have experienced yield increases as well, but spreads above treasuries do not compensate investors appropriately for risk in all areas.
Portfolio Adjustments and Current Positioning
We have been patiently anticipating a higher yield environment and have identified a pocket within fixed income that offers yields well above treasuries with less sensitivity to continued interest rate increases: Structured Credit. The opportunities in this asset class are represented by high quality, investment grade mortgage-backed securities and asset-backed securities (for example auto loans) with favorable yields. We allocated portions of our portfolios to Structured Credit to diversify our cash and short-term treasury holdings into higher yielding fixed income investments during the third quarter. These additions enhance the yield of our portfolios substantially.
Tighter financial conditions and higher debt servicing costs throughout the economy hold significant implications for portfolio strategy. As a result, we are comfortably maintaining low exposure to equities and continue to favor energy and quality. The energy sector offers investors a yield above 8% from the combination of dividends and share buybacks and quality provides sustainable profitability during weaker profit environments or even outright recessions.
We continue to believe that our dynamic approach to asset allocation will be favored over the next several years and our search for attractive entry points to add to risk assets with a high margin of safety is continuous. Some opportunities should present themselves as the long and variable lags of tightening policy flow through the economy. Others may be deferred until a more durable market bottom appears. Our job is to remain steadfast and patient.
As always, we are grateful for the privilege of allowing us to guide your assets forward. Should you have any questions or observations, please don’t hesitate to contact us.