Client Letter | 3Q 2023 Recap & 4Q 2023 Outlook
Rob Santos
Chief Executive Officer
As CEO and founder of Arrowroot Family Office, I specialize in the overall management of the firm. I also work with affluent families on providing bespoke family office services, which include tax-efficient advisory and financial planning, M&A advisory, family governance and process advisory, and philanthropic initiatives.
MCO
MyComplianceOffice
A complete compliance management software platform that helps financial services firms unify their activities across conduct and regulatory compliance.
Key Updates on the Economy & Markets
Rising Oil Prices Reignite Inflation Fears
Treasury Yields Rise Sharply in the Third Quarter
Consumers Face Higher Borrowing Costs
The stacked charts in Figure 3 show the Fed’s series of interest rate hikes have led to a sharp rise in borrowing costs. The top chart shows the interest rate on a 48-month auto loan has risen from 4.6% at the end of 2021 to 7.6% at the end of June. The middle chart shows the average 30-year fixed-rate mortgage rose from 3.8% to 7% over the same period. The recent rise in Treasury yields pushed mortgage rates above 7.30% during the third quarter, which implies that interest rates on auto loans also increased over the past few months.
The bottom chart illustrates how the rise in mortgage rates has impacted the homebuying process. According to the National Association of Realtors, the monthly house payment has risen from $1,249 at the end of 2021 to $2,052 at the end of June. Factoring in the rise in mortgage rates during the third quarter, the current monthly house payment is likely even higher. While many homeowners locked in low mortgage rates during the past few years, today’s homebuyers are navigating a combination of higher mortgage rates and home prices that are still elevated.
It’s not just homebuyers and consumers who face higher borrowing costs. Borrowers of all types, including businesses and commercial real estate owners, are adjusting to a new world with higher interest rates. For some borrowers, the math of higher monthly payments doesn’t work like it used to when interest rates were lower during the past decade. The looming question is whether borrowers can manage the increased interest rates and maintain their payments.
Data already indicates consumers, businesses, and commercial property owners are feeling the stress of higher rates. The percentage of auto loan delinquencies, which is defined as loans 90 days or more overdue, is rising across every age group, and there is a similar trend in credit card delinquencies. The rising number of Chapter 11 bankruptcy filings suggests businesses are also feeling the effect of higher rates, while some commercial real estate owners have made the strategic decision to hand keys over to lenders rather than invest more money in undesirable buildings. These early signs of stress suggest lenders and investors should be mindful of potentially above-average credit risk in the coming years.
Equity Market Recap – S&P 500 Ends the Third Quarter with a Slight Loss
Stocks traded down slightly in the third quarter, with most of the losses occurring in August and September as rising interest rates weighed on equity market valuations. The S&P 500 ended the third quarter with a -3.2% return, while the Russell 2000 Index of small cap companies returned -5.2%. The Nasdaq 100, which tracks growth stocks, returned -2.9%. Despite negative returns during the quarter, the major stock indices have still posted strong gains this year. The S&P 500 has returned 13% through the end of September, while the Nasdaq 100 has gained 35.1% this year after trading lower in 2022.
Moving down to the sector level, Energy was the top-performing sector as oil prices climbed nearly 30%. Communication Services was the only other sector to trade higher, while the remaining nine sectors posted single-digit losses. Defensive sectors underperformed as rising interest rates weighed on the Utility, Real Estate, and Consumer Staple sectors.
International stocks underperformed U.S. stocks during the third quarter as rising Treasury yields caused the U.S. dollar to strengthen. The MSCI EAFE Index of developed market stocks returned -4.9%, while the MSCI Emerging Market Index returned -4.1%. Year-to-date, international markets have underperformed U.S. stocks due to their lower exposure to both growth-oriented stocks and the emerging artificial intelligence industry.
Credit Market Recap – Bonds Trade Lower as Interest Rates Rise
The yellow line in Figure 4 shows bonds haven’t experienced a sequence of negative returns like the current trend since the 1970s, which was the last time the Fed aggressively raised interest rates to combat inflation. Factoring in the third quarter sell-off, four of the 10 worst quarters for the Bond Aggregate Index have occurred since the start of 2022. While savers are earning significantly more interest compared to the last decade, the higher interest income is being offset by falling bond prices.
Elsewhere across the bond market, riskier bonds continued to outperform higher-quality bonds during the third quarter. High-yield corporate bonds produced a total return of -0.3%, while investment-grade corporate bonds generated a -4.6% total return. The performance gap can be attributed to two factors. First, high-yield bonds typically have shorter maturities than investment-grade bonds. As a result, rising interest rates had less of an impact on high-yield bonds during the third quarter. Second, high-yield bonds offer a higher yield than investment-grade bonds to compensate for their increased credit risk. This higher yield boosted high-yield’s total return and offset a portion of capital losses.
Fourth Quarter Outlook – What to Watch?
After a challenging 2022, it’s been a good year for investors. Entering the fourth quarter, the S&P 500’s year-to-date return has already surpassed the average return for a full calendar year.
Several factors will influence how the market finishes this year, including the paths of oil prices and interest rates. Corporate earnings and economic data will also be at the top of many investors’ watchlists. The third-quarter earnings season starts in mid-October, and it will provide key insights into consumer spending and the impact of higher interest rates. On the economic front, investors will be focused on the labor market, the trajectory of inflation, and third-quarter GDP growth, which will be released in late October.
Our team will be tracking corporate earnings and economic trends throughout the fourth quarter to help guide portfolio positioning. The market is entering the final stretch of 2023, but there are still a lot of important data points to be released and questions to be answered before we turn the calendar to 2024.
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