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Market Review: After a strong first half of the year, the third quarter brought losses across virtually every asset class. The Standard and Poor’s 500 Stock Index fell 3.3%, the Russell 2000 Small Cap Index declined 5.1% and the MSCI All World ex-US International Index dropped 3.7%. Additionally, the Bloomberg Barclay’s Aggregate Bond Index declined 3.2% and Gold fell 3.7%. Positive categories were the Goldman Sachs Commodity Index, which jumped 12.8% and the U.S. Treasury Bill Index (a cash proxy) gained 1.3% which was the highest quarterly return in 23 years.
The Bond Market: The major market story was the carnage in bonds as the yield on the Ten-Year U.S. Treasury exploded higher by 1.2% during the quarter, finishing at a yield of 4.6% and knocking down the price by 5.7% (see chart next page). This is not solely attributable to the surprising strength of the domestic economy. Other significant factors have moved into the spotlight as highlighted by Fitch Ratings Service, which on August 1st downgraded the credit rating of long-term U.S. debt to AA+ from AAA. Fitch’s explanation included “this reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance…..”. For the fiscal year 2023, which just ended on 9/30, the actual U.S. budget deficit topped $2 trillion, or over 5% of GDP. In the past, this 5% threshold was only breached during periods of recession and high unemployment, and certainly not with the unemployment rate below 4%. At the current level of rates, interest expense will soon become a greater part of the budget than social security payments. Total U.S. debt is at a record 122% of GDP and Treasury auction sizes are expected to be almost 25% larger next year. This increase in supply is occurring as the Fed continues QT and steps away from buying U.S Treasuries and mortgage-backed securities. Fiscal tightening seems far off into the future as neither of the leading Presidential candidates, nor their parties, have shown any discipline. So, the upward pressure on rates reflects the question of who will buy all this new debt and more specifically what bond yields will be required to draw demand. Economic growth and inflation will be significant variables in this.
Equities: Despite the negative influence of higher rates, the S&P 500 remains up 13.1% year-to-date. The S&P will remain highly influenced by the mega cap tech stocks with the ten largest stocks in the S&P 500 comprising a record 32% of the Index at quarter end. These ten stocks carry a forward price-to-earnings ratio (next twelve months earnings) of 25.9. The remaining 490 stocks in the Index trade at a forward P/E of 16.8 which is much more in line with historical averages. Similarly, value categories are trading at levels making them very attractive relative to growth categories and small caps appear to offer tremendous value versus large caps. The conundrum is that while there is more value elsewhere these widely held tech behemoths have thus far shown defensive characteristics, holding their valuations despite the new interest rate paradigm, slowing earnings growth, and mounting anti-monopoly, anti-trust cases coming from all directions.
TINA is dead: The adage from the long enduring zero interest rate environment, There Is No Alternative (to equities), no longer applies. An investor can now purchase a Ten-Year Inflation Protected Treasury and receive 2.3% plus the rate of inflation for a riskless return that will solidly protect their purchasing power for ten years. Nominal bonds also offer above-inflation returns. This is leading us to truly allocate to fixed income in balanced accounts. Our decade plus of underweighting fixed income versus equities, and hiding in short-term bonds, generated significant inflation adjusted outperformance versus a traditional balanced portfolio. Given so much uncertainty, a possible recession, and increasing geopolitical risks, we are comfortable wading into fixed income after the greatest bond rout in history. In equity focused accounts, we believe the opportunity lies in less widely owned stocks and categories, as discussed above, though this may lead to performance drift versus the S&P 500 in the near term.
We thank you for your continued support and welcome the opportunity to review the specifics of your investment holdings and strategy.
Your Staley Capital Investment Team