Return of the Bond Vigilantes

Market Update for the Quarter Ending
September 30, 2023

Business Exit Planning

It appears that The Federal Reserve is just about done raising short-term interest rates in response to inflation. Inflation remains elevated, but nowhere near levels seen last summer. There is a chance for one more rate hike this year and perhaps additional hikes in 2024 if inflation remains higher than target. The Fed will likely continue with hawkish comments regarding inflation and the need to keep interest rates higher for longer to keep recent disinflationary trends in place. The goal is to avoid the mistakes of the 1970s when interest rates were cut too soon, which allowed inflation to rebound and grip the US economy for an extended period.

While the Fed controls the overnight fed funds rate, it was the substantial jump in market-driven U.S. treasury rates that stole headlines and impacted financial markets in the 3rd quarter. Specifically, the 10-year treasury rate increased from 3.81% to 4.57% during the quarter, and ultimately peaked at 4.99% in mid-October. The 30-year treasury rate increased from 3.85% to 4.70% during the quarter and touched 5.10% in mid-October. A bond’s price is inversely related to interest rates and bonds declined in the 3rd quarter.

Technically, treasury rates are determined by the supply of treasury securities and the demand for these securities by investors. However, the key fundamental drivers that investors will consider when buying and selling treasuries are expectations for economic growth and inflation.

Economic growth: data coming in hotter than expected

In a year when many were predicting an economic recession, growth has continually surprised to the upside. Economic growth has been reported at just over 2% in both the first and second quarters and the Atlanta Federal Reserve’s Growth Domestic Product (GDP) forecast for the 3rd quarter is over 4%, which would be the highest in nearly two years. The job market remains at historically strong levels with a 3.8% unemployment rate and 9.6 million unfilled job openings. Investors that are less fearful of recession will sell (or demand less) U.S. treasuries and buy riskier bonds and stocks with the goal of higher returns – thereby pushing treasury prices down and rates higher[1].

Inflation: declining but still elevated and slightly over target

Headline Consumer Price Index (CPI) inflation has cooled from just over 9% in June 2022 to 3.6% in August. The Fed’s preferred measure, the Core Personal Consumption Expenditures Index (PCE) recorded the smallest monthly increase in August since November 2020 and is running at just over the target 2.0% rate based on the last 3 months of annualized data. Clearly, we are in more of a disinflationary post-pandemic period, but many investors (along with the Fed) remember the persistent inflation of the 1970s and need more evidence that inflation is under control before claiming victory. Investors that are fearful of inflation will sell (or demand less) treasuries and buy assets such as stocks, commodities and real estate that can outperform in inflationary periods – thereby pushing U.S. treasury prices down and rates higher.

Investors suddenly demanding a higher risk premium for treasuries

Economic growth and inflation are the two traditional drivers of treasuries. However, fiscal concerns are mounting due to the substantial U.S. budget deficit that is growing with no end in sight. Suddenly higher interest rates have pushed the expense on interest payments to nearly 10% of the annual budget. It seems that politicians are ignoring the situation and the politics are so messy that there is a realistic chance for an “operational” default.

Enter the “bond vigilantes”. Bond vigilantes are investors that protest the policies of the issuer – in this case the U.S., to promote positive change. Bond vigilantes have woken up after a long slumber. They were last seen in the early 1990s to protest growing deficits and effectively pushed interest rates higher by boycotting treasuries. In response, the U.S. increased tax rates and cut spending and created a budget surplus over the following decade. Equity Strategist Ed Yardeni coined the bond vigilantes term in the early 1980s. We suspect that investors in treasuries are requiring greater compensation to offset default risk, even if minimal.

Stocks no longer the only game in town

Stocks were pushed lower throughout the quarter as investors digested higher interest rates. The S&P 500 Index declined 3.3% during the quarter yet remained up 13.0% for the year. A small handful of big technology stocks have lifted the major stock indices higher this year. The Equal Weighted S&P 500 Index declined 4.9% during the quarter and is only up 1.8% this year – demonstrating that most stocks are underperforming traditional indices this year. Further evidence of this trend is the Russell 2000 Small Cap Index declining 5.1% during the quarter while up only 2.5% during the first nine months of the year.

The strengthening U.S. dollar pressured international stocks lower in the 3rd quarter. The Developed Market MSCI Index declined 4.1% during the quarter but is up 7.1% so far this year. Emerging Market MSCI Index decreased 2.9% during the quarter and is up 1.8% over the first 9 months. One would expect the dollar strength to subside once we hit peak interest rates – and we could be there soon. If so, international stocks will have winds at their backs.

Global Asset Allocation Strategy

No changes were made during the quarter in the Global Asset Allocation Strategy. Stocks remain slightly overweight within the strategy due to additions made in 2022 near market bottoms. While broad market indices show a fully valued stock market, there are pockets of value within sectors and outside of a couple of the biggest technology companies. Small and mid-sized stocks represent close to 30% of total stock exposure and continue to be priced substantially below mean-valuations of the last 20 years.

The bond portfolio consists mainly of high-quality bonds and duration is shorter-term, which has worked well in the rising interest rate environment. Adjustments were made last October and December to position the bond portfolio for this year. The bond portfolio is designed to be more conservative and to offset risk from more aggressive stocks within the portfolio.

The strategy will remain diversified among sectors and geographically. Changes are opportunistically made based on market action and considers valuation and risk, among other fundamental factors. The investment time horizon is generally 5-7 years.

Focused Equity Strategy

Changes were made to the Focused Equity portfolio in August. The trades reflected some rebalancing, as we trimmed an outsized position and outperformer in Nvidia (NVDA) and punted due to concerns about China. Proceeds were added to 3M (MMM) and Taiwan Semiconductor (TSM), and a position was initiated in Disney (DIS).

Disney is an iconic brand and media company that is navigating the transition from traditional linear cable TV to streaming, owning kids media content, Marvel, Star Wars, ABC, ESPN, among others, along with the hugely successful parks business.

Streaming models have been popular with viewers due to the flexibility and easier navigation of streaming apps. However, currently only a few streaming companies are turning a profit. Disney has one of the largest streaming businesses with Disney Plus, and is leading the industry charge to reprice the business model to make it profitable. Disney has popular and valuable content, so we are confident that monetization will not be a problem. However, in our opinion the stock is underpriced due uncertainty surrounding the streaming business, plus there were short-term concerns about the writers’ and actors’ strikes.

3M was an existing position that we initiated in March. This is a large, diversified manufacturer whose stock was punished over litigation surrounding the Combat Arms earplugs used by the military, and by litigation regarding the manufacture of PFAS chemicals (a business they are exiting). The company reached a settlement through mediation on the Combat Arms litigation in late August for an amount less than feared. The PFAS issue will take many more years to play out, given that many other companies continue to manufacture and use those substances. We believe the stock is undervalued even considering the potential liabilities.

Taiwan Semiconductor was also an existing position, and represented a shift in exposure from Nvidia, although diversifying exposure within the semiconductor industry. Taiwan Semiconductor is the leading semiconductor manufacturer, making the chips designed by Nvidia, as well as chips designed by most other semiconductor makers, including Apple and AMD.

As mentioned, there has been a sharp disparity between a handful of giant technology stocks and the rest of the market in 2023. There has also been a sharp difference between growth and value, mostly reflecting those same stocks. We are fortunate to own a couple of these technology stocks, but valuation for some of these companies is getting extreme. Artificial intelligence should be a game changer, but a lot has to go right in coming years given that much of the upside is already priced into these companies.

As always, we seek to buy and own powerful business franchises that are trading at what we believe are temporary discounts to their intrinsic value. Valuation and projected earnings power are key components in the strategy. The portfolio will remain diversified in order to control risk and volatility. The focus remains long-term and tax efficiency is a significant element.

A return to normal and reasons for optimism

Today’s higher interest rate environment has proven to be challenging for both stocks and bonds. The “free money” period of the last 15 years is over. However, it is important to remember that interest rates remain relatively low based on longer-term historical trends. We have simply returned to normal. As expected, markets have been choppy as investors digest higher rates.

However, there are two reasons for optimism as we close out 2023. First, we are entering a period of historically solid investment results based on seasonal trends. The S&P 500’s strongest period began on the 197th trading day of the year (October 13th in 2023) and extends through year-end. The market has risen 70% of the time during this period since 1953, with an average gain of nearly 7%. October, November, December, and January are historically four of the most favorable months for investors[2].

A second reason for optimism is due to earnings that are expected to grow once again in the 3rd quarter after three straight quarters of decline. Per FactSet, analysts are expecting 1% earnings growth in the 3rd quarter and 8% in the 4th quarter. In 2024, earnings are projected to grow 8%. Stocks bottomed out in October 2022 in anticipation of the earnings recession. But we forecast better earnings ahead, which would allow for greater upside in stocks[3].

Of course, predicting short-term markets is difficult and can be a frustrating experience for investors. It is more important to focus on long-term results and target specific financial planning goals. As always, please feel free to reach out with questions about financial markets or your current standing compared to financial goals.

[1] “August Job Openings Top 9.6 Million, More than Expected as Job Market Remains Strong.”; Jeff Cox; 10/3/2023.

[2] Data from Sentiment Trader; “Tech Has Led This Market. Don’t Expect It to Change.” Barron’s; 10/16/2023.

[3] “Earnings Insight.” FactSet; 10/13/2023.

This content was published by Business Enterprise Institute, Inc., and presented to you by our firm. We appreciate your interest. Any examples provided are hypothetical and for illustrative purposes only. Examples include fictitious names and do not represent any particular person or entity.

All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results. 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. Past performance is not indicative of future results.

Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results.