3rd Quarter 2023 Investment Commentary


  • U.S. Federal Reserve Bank paused rate hiking cycle in June and may be finished with rate hikes
  • U.S. unemployment rate remains healthy at 3.8% as of September 2023 (up slightly from 3.5% in March)
  • Fixed income and cash interest rates offering very attractive yields (>5% on cash)
  • U.S. inflation rate has declined significantly from peak

Risks and Concerns

  • War in the Middle East significantly increases already high geopolitical tension
  • Equity risk premium at lowest level in 20+ years
  • Elevated risk of recession in 2024
  • CPI inflation rose at a 3.7% annual rate in September, but is down significantly from the peak of 9.1% in June 2022

The Quarter in Review

The third quarter began with relative calm in financial markets as investors began to expect a soft landing from the conditions of rising interest rates and historically high, but declining, inflation rates. Some economists began to walk back their predictions of impending recession. The U.S. Federal Reserve Bank (the Fed) made one 0.25% rate hike during the quarter, and signaled a pause in further hikes with the possibility that they may be finished raising rates. This was a huge relief to investors after a total of 5.25% in Fed interest rate hikes over the past 18 months. These rate increases coupled with inflation and the bond market response to both led to a surge in bond yields. The benchmark 10-year U.S. Treasury bond yield ended the quarter at 4.59%, the highest since 2007 (the 10-year Treasury yield has also briefly risen above 5% since the end of the quarter). These difficult bond market conditions caused the Bloomberg Aggregate Bond Index to finish down 3.2% overall for the third quarter.

Equity markets were also not immune to poor performance, and the S&P 500 index (U.S. large capitalization stocks) returned -3.39% for the quarter. While the index remained up 12.65% year-to-date at the end of the quarter, it was down 7.5% from its July peak. The Russell 2000 Index (U.S. small capitalization stocks) closed with -5.1% performance for the quarter. The MSCI EAFE Index (international stocks) finished down 4.1% during the quarter but remains up 7.1% year-to-quarter-end. It must be noted that shortly after the end of the quarter, war returned to the Middle East with an October 7th Hamas attack on Israel. In addition to the humanitarian tragedy this will no doubt cause, it will only add to the difficulties currently facing financial markets and likely contribute further upward pressure on oil prices.

Lastly, regarding the performance of the S&P 500 Index over the year thus far—the largest 7 stocks in the index now account for most of its performance—and by extension, the overall U.S. stock market. Google, Amazon, Apple, Meta (Facebook), Microsoft, Nvidia, and Tesla, known as the “Magnificent Seven”, now make up approximately 30% of the overall S&P 500 Index (by market capitalization), up from 21% at the end of 2022. Reminiscent of the “Nifty Fifty” collection of top large capitalization stocks that propelled the U.S. stock market in the 1970s, this lack of market breadth and participation from the smaller companies in the index is not indicative of a healthy overall market and economy. The following chart illustrates how the typical market-capitalization weighted version of the S&P 500 Index has dramatically outperformed the equal weighted version of the index so far in 2023 (opposite of last year, when it underperformed).

S&P 500 Yearly Performance Lead Over Equal-Weighted Index

Source: The Wall Street Journal, “How Surging Yields Brought the Stock Rally to a Halt,” 10/10/2023

Current Portfolio Strategy

Our current investment strategy is cautious overall, with a general underweight to equity and an underweight to higher risk equites. We are currently more favorable to bonds over equities due to high bond market yields on offer that have driven the equity risk premium to its lowest level in 20 years. The equity risk premium is the difference between the forward earnings yield on stocks (forward earnings divided by price) and the yield on the 10-year U.S. Treasury bond. The following chart shows that the equity risk premium is the lowest since June 2002, which indicates that equity investments are the least attractive relative to bonds than they have been in the last 20 years.

Our bond strategy has a low duration (interest rate sensitivity) designed to help protect against the rising interest rates that continued throughout the quarter despite widespread forecasts of declining rates. We have aimed to maintain a very low portfolio bond duration of typically less than 3 years (on average), which has resulted in significant bond outperformance vs. aggregate bond market indexes, which typically maintain a duration of about 6 years. We began to slightly increase bond duration earlier in the year with several small buys of the Vanguard Intermediate Term Corporate Bond Index but have paused this strategy for the last 2 quarters due to resilient interest rates. Duration extension is a strategy we will resume once it becomes clearer that interest rates have peaked, something that is likely to occur within the next several quarters, especially if the Fed declares an end to their rate hiking cycle.

Future Asset Allocation Changes and Considerations

The preponderance of the economic evidence currently available indicates challenging conditions are likely to continue in financial markets over the coming quarters, but there are a few causes for optimism, which we will review in the closing of this letter. To start, since 1931 there have been 19 U.S. Fed rate hiking cycles, and the economy avoided a recession in only 3 of those instances. Of even greater concern: PIMCO recently performed a study of 140 rate hiking cycles across the last 70 years of developed markets history and found that a recession followed these hiking cycles 75% of the time—90% of the time when there was elevated inflation at the beginning of the cycle. These data points alone would drive us to be cautious in our investment approach but there is still more cause for concern: The U.S. Treasury Bond market yield curve has been inverted for over a year (perhaps the best historical forecaster of recession), the Leading Economic Indicators Index has been in decline for over a year, and credit card balances are currently at record highs.

On the bright side: The inflation rate in the U.S. has fallen dramatically to 3.7% from its peak of 9.1% in June of 2022, as shown in the following chart.

Source: The New York Times, “Inflation Slowdown Remains Bumpy,” 10/12/2023

The Fed inflation target is 2% and the FOMC will meet 2 more times before the end of the year to decide on further rate hikes. CME futures markets are currently forecasting that there will be no further Fed rate hikes in this cycle, and if this comes to pass and inflation continues to decline, it is possible that we could achieve the vaunted soft landing and avoid a recession. If this outcome appears more likely, we will take steps to make investment strategies more aggressive with increasing allocations to U.S. growth stocks and longer duration corporate bonds.

Key Investment Takeaways

  • We are currently positioned defensively in both stocks and bonds
  • Equity and bond market performance struggled in the 3rd quarter as interest rates rose
  • We intend to continue an overweight fixed income strategy for much of 2023, until we see a stock market correction
  • High interest rates and declining inflation makes fixed income investments more attractive than they were in 2022
  • As inflation recedes, the U.S. Federal Reserve Bank is likely approaching the end of their interest rate-hiking cycle
  • A mild recession in 2024 is still predicted by most economic indicators

We will continue to monitor the market risks of this rapidly changing and difficult environment, frequently adjusting to help protect and grow your investment portfolio. As always, please feel free to call or email us with any questions or concerns.

Your Capital Advantage Team

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Disclaimer: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including those recommended or undertaken by Capital Advantage, Inc.), or any non-investment related content, made reference to directly or indirectly in this letter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this letter serves as a substitute for personalized investment advice from Capital Advantage, Inc. Neither Capital Advantage, Inc.’s investment adviser registration status, nor any amount of prior experience or success, should be construed that a certain level of results or satisfaction will be achieved if Capital Advantage, Inc. is engaged, or continues to be engaged, to provide investment advisory services. Capital Advantage, Inc. is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Capital Advantage, Inc.’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request or at www.capitaladvantage.com.

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