by Jordan Hucht, CFP®, ChFC®, AIF®

Q3 Review: Reality Check

After a first half of the year that saw financial markets soar in the face of pessimistic expectations, the rally had a reality check in the third quarter as the tide turned behind a convergence of new and old concerns.

Stronger than expected economic growth led to interest rates reaching new cycle highs while labor strikes, higher oil prices, and a looming government shutdown became the latest ingredients in the current recipe for market volatility.

Let’s unpack the main drivers of Q3’s moves and discuss what to watch moving forward.

Interest rates

As has been the case since the Fed began its inflation fight last year (and, honestly, for much longer than that), interest rates have been probably the biggest driver of changes in financial markets. All other things being equal, higher rates lead to lower stock valuations and lower bond prices. Such was the story of 2022, with both stocks and bonds posting negative returns.

Looking at the 10-year Treasury as a benchmark for context, rates jumped from approximately 1.5% to almost 4% during 2022. Then, during the first half of this year, rates gyrated a bit but ended where they started (just shy of 4%), based on the idea that inflation was headed down and the Fed was pretty much done with rate hikes. This (relatively) stable-rate environment during the first half of the year provided a docile backdrop for financial assets to thrive, along with other factors I’ll discuss below.

But as the summer wound to an end and the fall began, rates broke out of their year-long range and accelerated to the upside, with the 10-year yield now marching closer to 5%. Why? As always, there is a multitude of reasons, but the main driver is an extremely resilient (so far) economy that will likely lead the Fed to taking its policy rate a bit higher and, more importantly, holding it there for longer than the market had previously expected. That reality check sent rates climbing again. (Remember, the Fed controls only the federal funds rate; all other rates are set by the market based on supply/demand dynamics.)

The effect of this recent rate rethink on the stock market has been meaningful, with the S&P 500 declining close to 8% from its midsummer peak. That brings stock prices to essentially the same level they were in the summer of 2021 in the thick of the post-covid asset boom.

Economic growth

The most widely predicted recession of all time (pardon the dramatic liberty) didn’t happen this year, and corporate earnings have been better than expected. Specifically, GDP increased 2.2% and 2.1% in the first and second quarters, respectively, and current estimates for the third quarter are in the same ballpark. Furthermore, the labor market has been extraordinarily resilient, with the unemployment rate remaining below 4%.

With the recession remaining elusive, corporate earnings have been better than feared this year, and earnings expectations for 2024 have ticked up. That cocktail kept the market happy until the buzz wore off when the Fed suggested in August that its policy would remain tight longer than previously suggested. (In fairness, let’s remember that the Fed’s predictions of its future policy are just that – predictions – and their crystal ball is as cloudy as everyone else’s).

As we’ve discussed in the past, it takes time for monetary policy changes to impact the real economy, and clearly, it hasn’t been enough time to understand the full impact of the Fed’s rate hikes and quantitative tightening (selling bonds off its balance sheet). The market got overly excited about the prospect of a “soft landing” (defeating inflation without a recession) during the first half of the year and then had a reality check in the third quarter as it recognized the work that’s still ahead before the Fed can claim victory.

New developments

Several new risk factors emerged from the background to the forefront during the third quarter. First, and perhaps most impactful, is that oil prices have spiked markedly, with the price of crude oil increasing almost 30% in 60 days from under $70/barrel to more than $90/barrel. This is meaningful because higher oil prices, among other things, put pressure on consumers, who are already facing higher costs of goods and services, higher borrowing rates, and the impending resumption of student loan payments. The US economy is hugely dependent on the consumer, and as these pressures mount, discretionary spending will eventually be the fall guy.

Labor strikes in Hollywood and Detroit are adding additional uncertainty to the mix, though I don’t expect their effects to be overly impactful to the overall economy. But markets hate uncertainty, so they’re likely adding some amount of downward pressure on the margin.

Meanwhile, in Washington, lawmakers very nearly failed to reach a funding agreement by the October 1 deadline, which would have led to a government shutdown. This is not without precedent, as we’ve seen this 14 other times since 1980, and they are relatively short lived (the longest lasting 35 days) and somewhat benign in their economic and market impact. Here’s the bigger problem, though: as elected officials disagree over how to reduce our annual deficit, which has ballooned to 6% of GDP, it’s a reality check that we are on an unsustainable fiscal path.

As I wrote in my last newsletter, the US has been able to run large budget deficits because the US dollar is the world’s reserve currency, and as a result, there has been sufficient demand for US government bonds. As the total amount of bond issuance by the US government continues to expand, we grow closer to the point where the supply/demand dynamic changes, which would have major implications across the board. Having the world’s reserve currency is the most important economic advantage the US has, and a threat to that would be the ultimate reality check. That won’t happen overnight – and it can be avoided – but we should be paying attention.

What happens next?

For what it’s worth, the fourth quarter is historically a seasonally strong period for stocks, and interestingly, the past few times we’ve had a negative third quarter, it’s been followed by a positive fourth quarter. Personally, I interpret that as more coincidence than confidence, but it’s worth noting. More importantly, investing results should be measured in years and decades as opposed to months and quarters, so what happens in the next quarter is simply not that relevant for disciplined investors.

Looking fundamentally, the S&P 500 currently trades at approximately 17.5 times next year’s projected earnings, which is close to in line with the average over the past 10 years but higher than longer-term averages. Meanwhile, interest rates are currently much higher than the 10-year average and closer to longer-term averages. What does all that mean? It suggests that stocks are near the higher end of reasonable valuations (but far below the levels of 2021), and the pressure is on earnings to deliver as projected in 2024 to support prices going forward.

From an investing perspective, I think diversification will be key as we move forward in an environment of conflicting positives and negatives. Domestic stocks, foreign stocks, bonds, cash, and alternatives will all react differently as the macro backdrop evolves. Understanding the characteristics of each asset class and staying disciplined to an appropriate allocation – while ensuring you have a runway to meet near-term cash flow needs – is the path to long-term investing and financial planning success.

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Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.