Interest Rates and Their Effect on the Stock Market
Through the end of the third quarter, the US stock market was up +12.2%, while international stocks provided +6.9%, and the bond market was down -1.0%. While media headlines focused on a possible government shutdown, the United Auto Workers Union strikes, and the resumption of student loan payments this fall, markets looked longer-term as significant trends emerged. The bond market's reaction to the growing government deficit, a pause in rate hikes by the Federal Reserve, and the hype surrounding artificial intelligence were secular trends that took place during the third quarter.
During the third quarter, the rate on the 10-year US Treasury Note rose from 3.85% to 4.70% due to an increasing supply of Treasuries and better-than-expected economic news. (1) Starting with the good, the US economy has avoided a widely anticipated recession this year as higher interest rates have not deterred the US consumer from spending. The stronger-than-expected economy has dampened investors' demand for the risk-free haven of US Treasury bonds, causing interest rates to remain elevated. On the other hand, some portion of the growth in the US economy has been attributable to an increase in spending from Congress. The US government is running a $1.4 trillion budget deficit in 2023, which must be funded by the issuance of debt in the form of US Treasuries. The supply of debt offered by the government was met with low demand, resulting in the rate of US debt moving higher to spark investor interest. So, while there is both good news and bad news around the rise in interest rates, a higher level of US Treasury rates in Q3 caused investors to reassess stock valuations and their positioning in bonds.
Investors continue to focus on the Federal Reserve’s interest rate hikes. In September, the Fed opted to stop increasing the Fed Funds rate but reiterated their intention to keep rates higher for longer to ensure that they stamp out inflation. This has been a consistent message from Federal Reserve Chairman Jerome Powell. The market is now pricing in a 50/50 chance of one additional rate hike within the next year. (1) As the pace of inflation has slowed down, the need for additional rate hikes has decreased, resulting in a lower probability of a future hike.
During the third quarter, artificial intelligence (“AI”) technology continued to gain interest. AI at its core uses large amounts of data to provide insights and automation capabilities. Throughout the year we have noted the technology’s promise, but in the third quarter, we saw indications that AI stocks may have run too high too quickly. Nvidia, a bellwether for artificial intelligence, fell 12% in Q3 despite a record earnings call in which the company beat profit expectations and raised its revenue forecast. At the same time, ChatGPT one of the most popular AI chat tools, saw its number of active users decline for a third straight month. (4) So, while exciting, it remains to be seen what opportunities in AI will be durable over time and provide long-term returns for shareholders.
Over the past five years the S&P 500 has returned +28.7%, +16.1% (in 2020, where markets fell -30%), +27.0%, -19.5%, and +13.5% per year. Averaging those calendar year returns, the five-year annual return of the S&P 500 was approximately 9.8%, almost equal to the historical long-term average annual return of +10%. (1) Expect volatility to continue as we continue to navigate the effects of government spending from the pandemic and the war in Ukraine. However, outside of some over-extended stocks in the S&P 500, we see pockets of investment opportunity emerging.
We continue to favor high-quality companies over smaller speculative businesses when investing in the stock market. Quality companies with strong balance sheets can withstand higher interest rate environments better than debt-laden companies that see their profitability decline as borrowing costs go up. Within quality companies, large growth-minded companies are currently trading at 130% of their 20-year average valuations. (3) This is down from 140% at the start of September, but we are still at similar excessive levels of 2021 that give us pause to invest. Therefore, underneath the surface, we are searching for opportunities to invest in more attractively valued companies in areas such as cybersecurity and cloud computing.
At Juno, we believe that bonds have two primary roles in client portfolios: generating income and hedging against equity risk. We hold high-quality bonds because of years like 2008 when the aggregate bond index was up +5.2% while the stock market was down -38.5%. (1) Recessions are inevitable, but most investors can now achieve portfolio income goals by taking significantly less equity risk. For the past decade, we were stuck with the “TINA” acronym- “There Is No Alternative” to investing in stocks. During that era, it made little sense for investors to take on significant interest rate risk in bonds that only yielded 2.5%. Now, investors can earn a “risk-free” US Treasury bill return of 4.6% for 10 years. This is a powerful tool now available to achieve investor objectives while taking significantly less risk.
When determining how much risk you should take in your portfolio, it is important to have a clear understanding of what level of risk is needed to achieve your goals. If someone’s primary objective is to accumulate assets for retirement, and they are more than five years from their intended retirement date, then they can take on more equity risk without jeopardizing their accumulated nest egg. On the other hand, if an investor is in retirement and they rely on their portfolio for income, then they must balance their income needs with how long those assets must last. Understanding one’s willingness and ability to take risks, and finding suitable investments to match, is the foundation of good investing. Avoiding the big mistake in investing is just as important as finding the next big opportunity.
Thank you for your continued trust in Juno Financial Group.