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Market Review 3rd Quarter 2023

Market Review 3rd Quarter 2023

September 27, 2023

So, what has happened this year, and where are we headed?

It’s been an interesting year. Interest rates have continued to move higher on the long end, but the short end has kind of peaked at 5.5%. The end to Fed rate hikes seems to be upon us. The Fed did not raise rates at the September meeting but left open the possibility for a raise in November. Whatever they do, they are close to being done raising the Fed funds rate at this point.

This year, interest rates at the long end of the treasury curve have moved noticeably higher (from 3.9% at the start of the year to a current 4.50% on the 10-year treasury) as the economy has remained stronger than expected: consumer spending has been solid, hiring and employment have stayed strong, and GDP has remained up in the positive 2-3% range. We are clearly not in a recession as of right now.

But things are weakening up. Mortgage rates at 7.5%! and corporate borrowing rates in the 8-12% range have to be slowing up investment in many areas and high interest rates are also crimping consumer purchasing power. Throw in recently higher oil prices, and you can clearly see how things have tightened up for consumers. Student debt repayments restarting is a drag also.

Our income producing world of investments has had a good year so far. Muni funds not so much as they hold longer duration assets. Municipal bond funds have small positive total returns for 2023 so far.

High yield and floating rate funds have performed well and have raised their dividends considerably this year. Borrowers pain is our gain! Our funds buy assets that are other companies’ liabilities- and those borrowers are paying 2 and 3 times the borrowing cost of the average cost of the last 15 years. Total returns in high yield and floating rate bond funds are in the 3-6% range year to date for 2023.

The big discussion is that interest rates may stay higher for longer and that has gotten priced in throughout 2023. Recency bias of over a decade of low interest rates has everyone thinking that rates will come way back down in 2024 and 2025 as the economy weakens up and the Fed starts cutting rates again next year.

We are not really sure what happens in the next 12 months. The US economy is performing ok with rates up here as the cost of money has gotten radically repriced. I think the day of reckoning with overextended borrowers has not really started yet as maturities and the need to refinance low-rate debt have gotten pushed out to 2024 and 2025. Commercial real estate debt defaults are the overhang that everyone knows is coming.  

We hate to remind everybody that 2024 is an election year which can make everything go a little bit crazy.

How have asset prices in stocks and real estate performed in 2023? The average stock has done ok this year, but tech stocks have led the way higher on the back of soaring valuations. Whether they stay up here and go higher is anyone’s guess, but by historic standard metrics of value, large cap tech stocks are probably overvalued by about 20-40%. They pay small dividends and while great, strong cash flow businesses, at 25-35 times earnings, they represent poor value and will have a hard time generating strong forward returns and may also be susceptible to a big correction. Real estate prices have stayed high as supply has been limited because no one can afford to sell a home with a fixed rate mortgage! So, supply stays low, and demand stays steady leading to stronger home prices for the time being. That said, home affordability is at an all-time low.

After all is said and done, taking 6-8% cash yields on professionally managed, conservative, broadly diversified income producing assets with daily liquidity is the safest way to provide for retirement and also not have to panic at every market gyration. We have not changed an investment portfolio in our client accounts for quite a while. With yields up here, the next 3 years could provide strong 8-10% annual total returns once rates peak and level off. If rates do keep rising, mutual fund dividends and payouts will keep rising right along with it.

Either of these scenarios represents a positive potential outcome for strong total returns in fixed income over the next 3 years.

We think there is significant opportunity in fixed income going into 2024. Yields are the highest in over 15 years so buying future high income streams is finally possible again. We will cautiously say that interest rates can’t go too much higher from here without really damaging the US and global economy, hence we think that rates may be peaking. We shall see.

Best wishes for a great, beautiful fall season!