Q3 2023 Market Review: The Long Haul

Bel Air Investment Advisors must open this quarterly commentary with heavy hearts as we reflect on the traumatic terrorist attack against Israel on October 7th by the internationally recognized terrorist organization Hamas. Many in our community are directly affected by these horrific events, and all of us are heartbroken at the loss of lives and the setbacks of peace and stability in the Middle East. Although there are no words that can fully capture the gravity of these circumstances, Bel Air extends its unwavering support and a compassionate ear to all members of our community. In the face of adversity, we are reminded of the resilience and strength that unites us.

And now to our third quarter commentary for 2023…

Markets in 3Q

After a robust surge in stock prices during the first half of 2023, the third quarter brought a dose of reality. U.S. equities declined by 3.3%¹ during the quarter, causing year-to-date returns to decrease to a still impressive 13.1%. Bonds, which have now declined for four consecutive months, played a role in putting pressure on risk assets with the U.S. aggregate bond benchmark dropping by -3.3%²in the third quarter. Interestingly, as both bonds and stocks experienced declines simultaneously, commodities emerged as the standout performer, returning 4.7%³ for the quarter, mostly driven by the 28% rise in Brent crude oil price.

Higher For Longer

At the time of this writing equity markets were experiencing a mild correction. The downturn was triggered by a series of extensive monetary policy announcements, starting with the U.S. Federal Reserve on September 20^th and concluding after 11 central banks had their say over two days. Christine Lagarde of the European Central Bank referred to the current policy stance as a “lengthy race,” and most of the major players echoed a message of “keeping interest rates higher for an extended period.” On average, the Federal Reserve governors estimated that their benchmark rate, which currently ranges from 5.25% to 5.50%, would still be above 5% by the end of 2024.

^{Source: Bloomberg. Data as of September 30, 2023.}

As a result, bond portfolios with longer durations are now experiencing losses of nearly -11% year-to-date (YTD)⁴. Additionally, the U.S. dollar has gained strength on the belief that our interest rates will remain higher than those of other nations, increasing by 7% against other major currencies since reaching a low point in July. The bond markets, however, have been impacted by several technical concerns, including the prospect of an increase in the supply of Treasuries and a potential decrease in foreign demand. The growing federal deficit and the recent downgrade of U.S. credit have also contributed to concerns expressed by bond investors.

By comparison, stock market investors may have held a more sanguine view of interest rates and may have been slower to incorporate the news of prolonged high rates. Why? The prospect of rapid earnings increases driven by artificial intelligence, coupled with the enduring belief that the Fed might eventually capitulate to prevailing concerns about an impending recession and cut rates, could have been the underlying reasons.

The U.S. Economy Is Still Growing

The U.S. economy grew strongly at 2.1%, supported by positive surprises from consumers and the job market, which have been major factors in preventing a recession. However, durable goods like furniture and electronics saw declines, reflecting household behavior that is slowly depleting the savings built up during the pandemic. The measured consumer response is also good news for the inflation front. We believe that the projected core CPI (excluding energy and food) should continue its moderation from the current 4% level and gradually reach around 3%, based on recent disinflationary data in the rent and housing segments, which constitute one-third of the CPI. Furthermore, the fact that, during previous rate hike cycles, it took approximately 12 months or more to see the moderating effect on the economy bolsters our conviction that we are nearing the end of the hiking cycle.

^{Source: Bloomberg. Data as of August 31, 2023.}

An Engineered Slowdown

The behavior of the American consumer is a crucial factor in the rebound scenario, especially in the context of a higher-for-longer interest rate environment. On one hand, a significant number of American mortgage holders have fixed rates and can therefore withstand the rising rates. Additionally, many have already taken advantage of the low rates in the recent past to make significant purchases, such as appliances. With healthy balance sheets and a strong job market, consumers may exhibit the much-needed resilience to drive a new growth cycle in the next year.

On the other hand, higher interest rates will undoubtedly impact future consumer spending. There are signs of weakness, including a higher rate of credit card and home loan rejections, along with a record level of auto loan rejections. Moreover, the resumption of student loan payments is expected to reduce disposable income for consumers.

Considering these conflicting factors, we believe a modest slowdown in economic growth is more likely than a full resurgence in the coming months, especially when considering that consumer spending accounts for 70% of the U.S. GDP. As for inflation, the numerous rate hikes implemented by the Fed are beginning to manifest as economic growth decelerates, and disinflation is starting to appear in published data, even if we have to endure this uncertainty for the long term.

The Fallout of War in the Middle East

During even the most stressful of times, our clients have come to rely on Bel Air to provide prudent guidance. Sadly, there are many circumstances of violence and conflict around the world throughout history that guide our outlook on the economic consequences that may ensue. With the outbreak of war in Israel, our attention is heightened toward three specific areas:

The strength of the US dollar. During periods of instability, the dollar tends to strengthen as the currency most likely to safeguard assets. This can affect trade balances and the conversion of non-dollar sales back to US companies in the form of lower profits.
The price of oil. Any conflict in the Middle East can increase the price of oil. However, two things may hold it in check. As global oil prices are denominated in US dollars, a stronger dollar helps hold the price of oil down. Secondly, Saudi Arabia has already telegraphed a potential future increase in production if oil prices climb toward $100.
A new cold war. The world has already transitioned from the free flow of capital and globalization orthodoxy following the collapse of the Soviet Union to a new regime of bi-polar spheres of influence with democracies and their allies on one side and the authoritarian regimes of China and Russia and their allies on the other. Unfortunately, the attack on Israel and the ensuing conflict is being used and manipulated to further divide the world as China and Russia seek to rally support on the streets of the Arab world against the United States for its unwavering support of Israel.

We anticipate these days of strife to remain difficult and prolonged, but we are hopeful that the vast majority of people seek peace, freedom, and prosperity for themselves, and more importantly, for their children.

Sources

S&P 500 Index
Bloomberg U.S. Aggregate Bond Index
Bloomberg Commodity Index
iShares 20+ Year Treasury Bond ETF