To many people, judging from economic and political news since the summer, the world may seem more uncertain than ever.
On the distressing side, rising tensions in the Middle East could spill into regional armed conflict. Closer to home, the US government struggles to secure leadership in Congress, highlighting dysfunction at a pivotal time. And, in a perverse twist on usually positive news, better than expected US jobs growth and strong consumer spending raise concerns that rates must stay “higher for longer” to tame the economy and ward off inflation.
While we cannot predict events, we are used to investing in tumultuous times. We continue to expect a very volatile period in financial markets heading into 2024.
We’ll put recent events in context in this commentary, but we should first say that about 18-months ago we began to prepare for this volatility. We recognized that stocks and bonds alike tend to struggle when rates start to rise, inflation begins to increase, and the economy ultimately slows. As appropriate for clients, we introduced defensive equity allocations, trimmed select higher-risk opportunities, focused on high-quality investment grade fixed income, and emphasized very short maturities along the way, as part of our diversified portfolio strategies.
We believe this approach is still appropriate for those investing for the medium- and long-terms, with a few adjustments as markets have evolved. We do recognize that, for ultra long-term investors, there are compelling contrarian opportunities to consider, which we’d be happy to discuss.
Market Response to the Headlines
Financial markets reacted negatively to the headlines, as you might expect. As of October 20, the S&P 500 is down almost 8% since July 31, and more economic-sensitive sectors like small stocks, banks, and industrial companies are down more.
Counter to what you might expect during times of stress, yields in fixed income went UP rather than down (bond yields move inversely to prices; typically, in stressful times, investors buy bonds which pushes prices up and yields down). Consider that the 10-year Treasury yield climbed from 3.9% on July 31 to almost 5% now, the highest levels in over a decade. Similarly, utility stocks—often seen as a fixed income proxy—are down 12.8% since July 31, reflecting the impact of higher rate expectations.
Why did longer-term yields go UP rather than down? A big reason is that investors now think there will be fewer rate cuts next year. In public appearances this summer and fall, Fed officials continue to emphasize that inflation is well above target and that rates could stay elevated. In addition, the US government continues to issue debt even as the Fed is no longer actively purchasing that debt in the open market. When supply exceeds demand, prices usually fall—which for bonds, puts upward pressure on yields.
We continue to expect the following over the next 18 months:
- The Fed may indeed hold rates steady in November and December, despite lingering inflation pressure. Yields are at historic highs already, which is crimping economic activity and arguably “doing some of the Fed’s work.” The Fed may require another rate hike in early 2024, but we suspect we are toward the later stages of rate hikes overall.
- That said, rates should stay elevated through 2024. It will take time to absorb higher rates in many sectors (think of all the homeowners with low fixed rate mortgages who will stay put) and supply will likely exceed demand in bond issuance, whether investment grade or high yield.
- The economy should continue to weaken, experiencing “rolling recessions” by sector rather than one major downdraft. Some parts of the economy are stronger than others, and slowing may filter through at different stages. Banks are already much more restrictive in lending, and many companies will hesitate to issue new debt at materially higher rates. We expect economic activity to slow as a result, but it takes time—and longer than historical evidence would indicate, given how fixed rates are embedded in our economy.
- Inflation remains a wildcard. It is clearly slowing from year ago levels, yet demand persists in many areas of the economy, keeping wages sticky and employment high. For reference, bond markets expect inflation in two years to be around 2.4%, although that outlook has climbed from lows this summer as investors contemplate “higher for longer.”
We continue to expect volatile markets, requiring investors to have patience and encouraging many to manage their spending and maintain a healthy (corporate or household) balance sheet. We recommend no changes to portfolio allocations unless your risk profile has changed. Please reach out to us if you have any questions or concerns.
 For example, as long-term rates improve compared to short-term, we have begun extending duration in client fixed income portfolios by selectively buying bonds with longer maturities. We consider investment grade, longer-term government bonds to be attractive in the event of possible recession, and the relative term premium has improved.
 According to the futures market, expectations are that the fed funds rate will be 4.7% by the end of 2024 (up from a forecast of 3.7% last July). Currently, the effective fed funds rate is 5.3%. Futures are arguably implying two or three cuts next year.
 In modern times, the Federal Reserve has been one of the largest buyers of US Treasurys supplied to the market. Recall that during the pandemic, the Fed bought Treasurys and mortgage-backed securities actively to keep long-term rates low so that the economy could recover.
 We expect the Fed to continue to shrink its balance sheet—meaning, letting the bonds it holds mature and NOT buying new issues in the open market—unless the economy really struggles. We believe reducing liabilities on its balance sheet would help improve the Fed’s policy options in the future. Debt on the Fed’s balance sheet ballooned to about $9 trillion at its peak. It has now fallen about $1 trillion.
 Oddly, delinquencies are up but not yet spiking, and risk spreads in high yield markets are up but generally in-line with more stable economic times. We expect pain next year as companies refinance at higher rates, which will crimp cash flow. Consider that rates on high yield debt can now exceed 9%, compared to current debt carrying on average 6%.