The Third Quarter got off to a strong start in July, with stocks reaching their highs for the year by month-end. It was the strongest start to a year for Nasdaq since 1975 and the best for the S&P 500 since 1997 (Dow Jones). July also saw market breadth encouragingly widen as small- and mid-caps led for the month.
However, markets also reached overbought territory and were overdue for a pullback, consolidation, or correction, which are normal after outsized gains. Volatility rose in August when credit rating agency Fitch downgraded the US long-term Treasury debt rating one notch, from AAA to AA+, which unnerved markets. Growing debt and “erosion of governance” stemming from ongoing debt ceiling political brinksmanship were noted by Fitch. It was the second downgrade in our nation’s history, with the first in 2011, and bond yields rose.
Small- and mid-cap stocks led the market on the downside in Q3, reversing their strong July gains. The small-cap Russell 2000 fell 5.5% but remained up 1.4% for the year. The mid-cap S&P 400 slid 4.6%, and closed Q3 up 3% YTD. Market leaders for the year, the tech-heavy Nasdaq and benchmark S&P 500, also tumbled in Q3 losing 4.1% and 3.7%, respectively. However, their YTD gains remained impressive at 26.3% and 11.7%, respectively. The storied but lagging Dow Jones Industrials fell 2.6% in Q3, though the Dow remained positive for the year up a scant 1.1%.
Overseas, developed markets also saw losses in Q3, with the benchmark MSCI EAFE index falling 4.7% to finish +4.5% YTD. A strong US dollar contributed -3.3% to the losses versus local currency terms. The European Central Bank raised interest rates twice in Q3 but easing inflation to 4.3% may put the ECB on pause soon. Emerging markets slipped into negative territory for the year at -0.4%, following a 3.7% Q3 decline and were pressured by continued economic weakness in China.
The Fed, inflation, and interest rates remained at center stage in Q3. The Fed raised interest rates 0.25% to 5.25% at its July FOMC meeting in its ongoing inflation battle. It was the 11th rate hike since last March, totaling 5.25%. While inflation ticked up 0.3% in August to 3.7%, its downtrend from 9.1% last June remains on track. The US labor market remained strong and though unemployment edged up to 3.8% in August, it remained under 4% for the 19th consecutive month. The Fed kept policy rates unchanged at its September FOMC meeting.
Given the sticky inflation reading in August and comments by Fed Chair Powell, including an upgrade in the Fed’s US economic outlook for 2023 and 2024, which further strengthened the case for a soft landing, interest rates rose across the yield curve in Q3. Markets began pricing in “higher for longer” Fed policy, which may or may not include one more hike. This put upward pressure on interest rates in Q3, and particularly in September when the benchmark 10-year Treasury Note yield rose 0.50% to 4.59%, its highest yield since 2007. The Bloomberg Aggregate Bond index fell 3.4% in Q3 and closed in negative territory for the year at -1.2%.
Q3 was somewhat of a microcosm of 2022, with rising interest rates driving equity volatility and losses for both stocks and bonds, albeit on a more palatable scale. Inflation and the Fed are not the only catalysts for rising rates. A still massive Fed balance sheet, a burgeoning U.S. fiscal deficit requiring growing government debt service at now higher rates, and dysfunction in Congress continue to threaten US credit ratings.
The Outlook
The rise in volatility presented a challenging end to the Third Quarter for investors with consecutive monthly losses in August and September. While the “higher for longer” interest rate outlook enveloped the market’s mindset in Q3, we are clearly closer to the end of the Fed’s aggressive interest rate hiking cycle that began last March. The futures market is pricing in less than a 30% probability of another final rate hike by year-end. On the other side, the market isn’t pricing in a rate cut until mid-2024 and the Fed now only sees two rate cuts for all of 2024 beginning in Q4-24, which aligns with the new mindset.
The economy has been resilient amid the aggressive Fed rate hikes and has largely outperformed expectations. S&P 500 corporate earnings have surprised as well, with 76% beating expectations for Q2. Q3 earnings season now gets under way and will be closely scrutinized. While the economy is still expected to slow going forward, as noted above, the Fed upgraded its 2023 and 2024 economic outlook, which supports a soft-landing scenario. Risks for a mild recession linger, but the risk of a severe recession remains low, with Goldman Sachs recently forecasting that risk at just 15%.
Though surpassing the end of July YTD market highs is a big challenge, our Year-End Outlook remains cautiously optimistic, despite a call for continued volatility in the near term. The horrific attack on Israel by Islamic terrorist group Hamas has escalated tensions to war in the Middle East and will add to the near term volatility. Support for Israel globally from the West has been overwhelming and led by the US.
As Q4 begins, so does generally positive seasonality for the market, particularly November and December. Additionally, studies by Ned Davis and Goldman Sachs have shown when market returns are greater than 10% through July, followed by declines in August, or August and September, the Fourth Quarter has delivered strong returns for stocks historically. However, past performance is no guarantee for future results.
It's important to remember, we are still in the recovery process from 2022. We continue to urge investors to remain resilient with their investment portfolios and maintain a disciplined, long-term focus. (See Dealing with Market Volatility below)
- Remain well-diversified
- Maintain discipline and patience
- Focus on the long-term
- Review your Risk Tolerance
Call your Nelson Advisor today at 800-345-7593 to discuss any concerns and review your portfolio.
~Your Nelson Securities Team
*Past Performance is No Guarantee for Future Results
