After three straight quarters of positive returns in equity markets, stocks pulled back during the third quarter of 2023. While gaining meaningfully over the prior year, US, international developed, and emerging markets were all down roughly 3-4% for the quarter. The recent market performance continues to be heavily influenced by interest rates and the anticipated direction and level of those rates. Overall, economic data is generally trending in the right direction, but uncertainty remains about how much further the Federal Reserve will raise rates and how long they will hold rates at restrictive levels. Job gains have shown signs of slowing, while unemployment remains low and economic activity remains robust. While trending down, inflation remains higher than the Federal Reserve’s 2% target. The Federal Reserve held two meetings during the quarter, raising the federal funds rate by 0.25% at the first meeting in July and holding at their current 5.25-5.5% target at their second. Bond markets also pulled back during the quarter as investors assessed the probability that interest rates may be held at higher levels for longer than previously anticipated.
After a strong run for the prior three quarters, US stocks fell modestly during the third quarter of 2023. Small-cap growth stocks and REITs were among the weakest performers. Absolute returns for the last year have been strong, generating just over 20% for the CRSP US Total Market Index. Over the past year, large-cap stocks have outperformed their small-cap counterparts. After a strong 2022, value-oriented equities trailed growth stocks, which have returned to favor so far in 2023.
Developed international and emerging markets stocks performed similarly to US markets for the quarter, with developed markets down -4.1% (as measured by the MSCI EAFE) and emerging markets down -3.0% (MSCI EM). Over the past year, developed international markets have outpaced both the US and emerging markets, gaining 25% (MSCI EAFE). While still generating positive returns, with a gain of 11.7% (MSCI EM), emerging markets gained a little less than half of that of developed markets.
Within fixed income, performance was negative across sectors during the third quarter. This result was largely attributable to investors weighing recent economic data and Federal Reserve guidance. During the quarter, investors appear to have priced in a higher probability that the Fed may hold rates at higher levels throughout much of 2024. Over the past year, overall returns for fixed-income investments have been modestly positive. More credit-sensitive sectors (like corporate bonds) have generated the highest results for the period. For investors in tax-sensitive portfolios, municipal bonds have been one of the strongest sectors over the last year, with even stronger relative results when compared on an after-tax basis.
As we do each quarter, we share illustrations or ideas that we believe can provide value and perspective for our investors. The illustration we wanted to share this quarter came from JP Morgan’s Guide to the Markets. We often speak with investors about the concept of markets pricing in “known” variables and the fact that market movements are often driven by unexpected or unanticipated information. For example, if everyone expects interest rates to move a certain amount and in a certain direction, and they do, then markets will be fairly stable. However, if expectations change, as during the third quarter, markets generally reprice quickly. The illustration below helps us understand what market participants and the Federal Reserve currently believe the future may hold for interest rates.
Further, we have recently heard from many investors questioning why they shouldn’t invest in money market funds and short-term vehicles given the current yields available. This illustration also helps us understand the limitations of that approach.
Short-term interest rates, like those available by investing in saving accounts, money market funds, and ultra-short bonds, correlate very highly with the federal funds rate. The Fed and average market participants expect these short-term rates to come down over the next several years. While these are only “best guesses” and almost certainly not going to be completely accurate, if rates do start coming down, investors will no longer be able to earn the rates they currently earn on short-term investments.
For example, consider this simplistic hypothetical scenario over a five-year time frame: An investor could purchase a money market that yields 5% this year, 4% next year, and 3% in years three through five. Alternatively, the investor could purchase a five-year bond at 4%. Which one works out better? The first scenario compounds to a 19.3% total return while the second to 21.7%. Further, the five-year bond could offer appreciation and diversification if rates fell more than expected, as they often do during times of economic difficulty. Shorter-term investments would experience very little or no price appreciation.
Investing in longer-term (i.e., longer duration assets) may offer an ability to lock in higher yields over the entire time horizon of an investment, but also can provide additional benefits if market rates decline more or faster than expected. That could happen if economic data weakens more dramatically than expected or a currently unforeseen event drives a risk-off trade. We believe intermediate fixed-income investments are important for return potential and diversification benefits as we look forward.
Each quarter, Collective Wealth Planning, with the help of our investment partner First Ascent Asset Management, provides transparency and seeks to clearly communicate what is driving performance for portfolios. However, as long-term investors we believe it is important to note that any single period (especially a period as short as a quarter) can be skewed or limited in informational value and stress the importance of the longer-term perspective on portfolio positions.
Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.