Market and Economic Outlook - Released 9/30/23

Key Takeaways:

• With continued strong data points, the probability of a soft landing has been increasing but we are not out of the woods yet. We suggest slightly favoring bonds over stocks in multi-asset portfolios.
• Valuations are not overly concerning to us, but we are still monitoring what impacts higher rates may have on investment opportunities within stocks.
  
• As the Federal Reserve approaches the end of its tightening cycle, we feel a shift towards longer-duration bonds is warranted.
  

The expression, "A bird in the hand is worth two in the bush" has been used in various forms across many cultures for centuries. As we assess the investment opportunities today, this ancient axiom seems as relevant as ever. 

Today, the proverbial bird in hand appears to be investment grade bonds, which are trading at the highest yields we have seen in years. Conversely, stocks do not look overly expensive, but lofty expectations for earnings next year give us pause in a slowing economy. You could say stocks may have some risks hiding in the bush. The return potential in stocks is higher over the long term, but the tradeoff there is greater volatility. We believe the hurdle for taking on stock market risk is higher today with bonds providing a compelling alternative. Therefore, we suggest slightly favoring bonds over stocks in multi-asset portfolios while encouraging our clients not to lose sight of the risk tolerance which makes sense for them. 

Market Pause

Markets took a pause in the third quarter after sharp upward moves in the first half of the year with the S&P 500 declining -3.3%, and small cap stocks returning -5.1%. International developed stocks were also down 4%, and emerging markets fell – 2.8%. Yields rose during the quarter with the 2-year treasury now comfortably above the 5% threshold closing the quarter at 5.05% and sending bonds down -3.2% (Figure 1). 

Fed Hiking Finished?

Headline inflation bounced back up in the quarter from 3.0% in June to 3.7% in August with food rising 4.3% over the past year and rents rising over 7%. Core inflation, which many feel is a better barometer for where future inflation is headed, continued its march down and now stands at 4.3% over the past year through August. PCE inflation, the preferred measure of the Fed, has ticked up as well and remains well above the 2% target (Figure 2). The Federal Open Market Committee (FOMC), after a pause in June, decided to raise the federal funds rate once more to a target range of 5.25% to 5.5%. The question now becomes “Will the Fed hike once more, as is in their projections, or was this the final rate hike of the cycle?” 

There are notable areas of strength that could either 1) allow the Fed to hike rates once more or 2) feed into the “higher for longer” interest rates narrative. Job openings have continued to come down from over 11 million to start the year to 8.8 million at the end of July. And while the JOLTS data has shown some loosening within the labor market, initial jobless claims continue to remain on the lower end. The Fed also came out with their economic projections (Figure 3). These show they expect the unemployment rate to rise just to 4.1% by the end of 2024 which is very close to their longer run projection of 4.0%. The 4-week average for initial claims has held within a range of 220-240 thousand since late July after peaking near 250,000 mid-year. The consumer also remains resilient amid rising prices. Retail sales in July rose 0.5% and rose another 0.6% in August rising more than expected.

Hard vs. Soft Landing

With these continued strong data points, the probability of a soft landing has been increasing, but we are not out of the woods yet. Much of the spending by consumers has been in the form of credit with credit card balances having risen over the $1 trillion mark for the first time according to the New York Federal Reserve (FRB). The cost to service these balances is going to increase from that of just a year ago and credit card delinquencies are beginning to rise primarily across those with lower incomes.

Beginning on October 1st, student loan payments will restart and could keep retail sales from continuing the upward momentum they have shown recently (the amount of student loans outstanding at the end of the second quarter was $1.77 trillion). Opinions on the extent of the resumptions impact vary and we will get more clarity through the end of the year and into 2024. Beyond this, we have also seen the price of energy increase with both Brent and WTI above $90 a barrel also having an impact on consumer spending. Brent rose 27.3% and WTI 28.5% in the quarter after dropping in the back half of 2022 and the first half of 2023.

Stocks at an Inflection Point

As we discussed last quarter, stock performance in the first half of the year was robust, driven mostly by strong performance in some of the top weighted names in the S&P 500. While the rally cooled some in August and September, valuations for the index still appear to be modestly elevated when evaluating them on a price-to-earnings multiple basis. On their own, valuations at this time are not overly concerning to us, but we are still monitoring what impacts higher rates may have on stock market valuations and the investment opportunities within stocks.

In our view, we have yet to see a significant impact of higher interest rates on corporate financing costs. Per research from Goldman Sachs, over $2 trillion of corporate debt matures in the next 3 years (GS). Even if rates fall below current levels, as companies go to refinance existing debt, they will likely need to do so at much higher interest rates. Many companies have recently passed on costs from inflationary pressures to sustain their margins. Because of this, they may be less able to pass on higher borrowing costs too. This dynamic could cause pressure on earnings growth as interest expenses rise, which could put pressure on price investors are willing to pay for companies with high debt burdens.  

Neutral View on International

International stock valuations still look cheap compared to their U.S. peers, but it remains to be seen whether these stocks may experience sustained outperformance relative to the U.S. Although international stocks experienced some outperformance last year, U.S. stocks have still benefited from a strong decade of outperformance versus international developed market stocks (Figure 4). Despite attractive valuations, sector allocations, exchange rate considerations, and geopolitical risks continue to give us a neutral view on investment opportunities within international stocks. 

Given this backdrop, we remain cautious on stocks overall, but we are still searching for selective opportunities down the market capitalization spectrum where valuations are more attractive. It is here where we are looking for value in strong businesses with good balance sheets that can navigate the economic uncertainties ahead. 

Up Up and Away

Despite core measures of inflation trending lower and the Federal Reserve nearing the end of their hiking cycle, Treasury bond yields rose during the quarter (Figure 5).

Recent economic growth readings have made investors consider if the Fed is less likely to cut the federal funds rate significantly next year. Other factors for the increase include Fitch downgrading he United States from triple-A status, and expectations the U.S. Treasury needs to increase issuance to fund the budget deficit. 

With bond yields hovering near multi-decade highs, our outlook is favorable. Historical data shows starting yields are a significant determinant of investment-grade bond returns, with approximately 95% of returns over 5-10 years being explained by initial yields for bonds held to maturity. The outlook is especially promising with potential for slowing inflation, which could lead to lower interest rates and increased total returns over the next few years. As the Federal Reserve approaches the end of its tightening cycle, we feel a shift towards longer-duration bonds is warranted and have begun positioning to have a longer duration than the broad intermediate term bond market. While the risk of rising interest rates is prevalent, higher coupon income can better offset short term losses.

Credit spreads, or the difference in the yield of two bonds with the same maturity remain tight. Currently, the market is showing little concern about a recession which could negatively impact the ability of corporations with weak balance sheets to meet their debt service obligations. Due to the low credit spreads, we continue to favor higher quality intermediate bonds as we do not believe we are being paid to take additional credit risk.  

Bonds for the Long Haul

Unfortunately, most investors tend to look in the rear-view mirror to make investment decisions. After 2022, a year where the Bloomberg Aggregate Bond Index produced poor returns, many are seeking lower risk options within their fixed income portfolio. We believe it makes sense for an investor with a short-term goal to try to match the duration of their holdings to their liability. In certain cases, using cash equivalents or money market to reach this goal is prudent. However, for long-term investors they could be better off holding their intermediate term bonds. 

We compared investment grade bond returns to returns on cash equivalents (Figure 6) by measuring rolling returns of the Bloomberg Aggregate Bond Index to cash using the FTSE Treasury Bill 3 Month Index as a proxy. In 31.4% of the rolling 1 year periods cash outperformed. However, over a longer period like 3 and 5 years it was rare for an investor to be better off investing in cash compared to intermediate term bonds. Over the 10- and 20-year periods bonds outperformed in every rolling period.  

The Bottom Line

Investing with a long-term perspective usually takes precedence over short term thinking. Investment grade fixed income seems compelling while we remain concerned about the impact an uncertain economic future could have on stock prices in the near term. While our investment process looks to capitalize on short-term dislocations, we always advise clients not to lose grip of their long-term plan.  

*Forecasted average annual returns of COUNTRY Trust Bank Wealth Management

Source: Morningstar and COUNTRY Trust Bank® - See Definitions and Important Information below

COUNTRY Trust Bank® Wealth Management Team

• Chelsie Moore, CFA, CFP® - Director, Wealth Management & Financial Planning
• Kent Anderson, CFA - Portfolio Manager
• Jonathan Strok, CFA - Portfolio Manager
• Michelle Beckler - Investment Analyst
• Samantha Reichert - Investment Analyst