Quarter in Review
Despite a promising start, financial markets faltered in the third quarter.
Stock markets extended their strong gains from the first half of the year into July as investors grew increasingly confident that a soft economic landing could be achieved. However, the historically challenging months of August and September once again proved disruptive to markets resulting in broad-based losses for stock and bond investors in the third quarter.
What changed for investors?
Investors entered the third quarter generally optimistic about the U.S. economic outlook and increasingly confident the Federal Reserve (Fed) was on the verge of delivering an historically elusive soft landing – tightening monetary policy just enough to tame inflation but not so much to tip the economy into recession. This relatively benign inflation outlook led investors to not only price an imminent end to interest rate increases from the Fed this year but also to expectations the Fed would meaningfully cut interest rates in 2024. Financial markets, especially stock prices, were buoyed by the combination of resilient economic growth and expectations for less restrictive monetary policy on the horizon.
Inflation has decelerated but remains elevated
However, this optimistic outlook was challenged during the quarter as economic data reminded investors that although inflation has decelerated markedly from a year ago it remains quite elevated relative to recent history and the Fed’s 2% target.
These concerns were intensified by hawkish monetary policy comments from members of the Fed and updates to the Fed’s summary economic projections released in September suggesting that the Fed intended to maintain interest rates at elevated levels for a longer time than investors had been expecting.
The response was a sharp rise in interest rates, which led to the broad-based declines in stock and bond markets last quarter. Notably, the yield on 10-year U.S. Treasury bonds rose to levels last seen prior to the Global Financial Crisis of 2008.
INVESTMENT OUTLOOK
Despite a challenging third quarter, U.S. stock markets remain firmly in positive territory through the first nine months of 2023. These gains in stock prices are likely attributable to historically pessimistic investor expectations at the beginning of the year, which set a low bar for a surprisingly resilient U.S. economy to exceed, as seen in the strength of U.S. economic surprise indices in the first half of the year.
Unsurprisingly, investor expectations have ratcheted up alongside the strong stock market gains during the year leaving financial markets more susceptible to negative surprises, like the ones described earlier regarding Fed policy and interest rates.
We have written in recent quarters about the disconnect between the strength of current economic activity and elevated warning signs about the risk of a slowdown in future economic activity based on leading indicators, such as an inverted yield curve and persistent declines in leading economic indices. Based on historical precedent, the sharp tightening in financial conditions orchestrated by the Fed and other central banks is likely to negatively impact economic growth, albeit with an indeterminate and seemingly extended lag in the wake of pandemic-induced distortions in the economy and financial markets.
PERSPECTIVE FOR INVESTORS
We continue to advocate caution and emphasize risk management in investment portfolios amid an uncertain economic and financial market backdrop.
We believe diversification is paramount for investment portfolios in the current environment. While the sharp rise in interest rates over the past 18 months has been painful for bond investors, the higher yields now available have markedly improved the long-term outlook for bond markets, in our opinion. We believe bonds, and even cash, currently offer attractive yield and total return potential for investors and that these historically lower risk asset classes will once again provide important ballast to investor portfolios in the event of an economic slowdown or recession.
Despite the improved prospects for bond markets, we continue to believe that stocks serve a critical role in the portfolios of long-term investors. Within stock allocations, we encourage investors to focus on quality companies with durable earnings and strong balance sheets that should prove more resilient if the economy slows or financial markets wobble.
Lastly, it is critical for investors to remain disciplined and focused on their long-term financial plans while staying engaged with their financial advisors.
Authored by the Freedom Capital Management Strategies® Investment Team | July 2023 Securities and Investment Advisory Services offered through Founders Financial Securities, LLC. Member FINRA, SIPC and Registered Investment Advisor.
Securities and Investment Advisory Services offered through Founders Financial Securities, LLC. Member FINRA, SIPC and Registered Investment Advisor. This material contains the opinions of the author(s) but not necessarily those of Founders Financial Securities, LLC and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed. Investors should consult their financial, tax, and legal advisors before making investment decisions. Past performance results are no indication of future returns, and all investments may result in loss of principal.
