Third Quarter 2023 Market Commentary

Sticking the Landing?

October 2023

Equity markets in the third quarter pulled back, with the S&P 500 down 3.6%, Dow Jones Industrial Average down 2.6% and the Nasdaq down 4.1%.  Equity market pullbacks of ~ 5% are typical and occur 2-3 times per year on average, however each pullback has its own explanation.  As has been a consistent theme in equity investing over the past several years, Fed interest rate policy has captured investors’ focus and has been the predominant influencer of market behavior in 2023.  The third quarter pullback was largely due to the Fed signaling that interest rates will stay higher for longer, and investors adjusting their expectations lower for a soft economic landing and a more accommodative interest rate environment.

While the quarter was a negative one for equities, inflation and interest rate factors have hampered returns in other asset classes, including fixed income, with investment-grade corporate debt down ~ 6% in the quarter.  As discussed in this market commentary, inflation and rising interest rates hamper asset values across a broad spectrum of investment strategies.  In the third quarter, the equity markets fluctuated largely based on rising and then falling hopes for a shift of Fed policy to a more stable or accommodative interest rate policy.

Markets Hang Onto Hopes for a Soft Economic Landing

            Markets rose throughout the first half of 2023 largely in anticipation of a moderation of Fed interest rate policy and potential interest rate cuts occurring in 2024.  Relatedly, as the labor markets have shown signs of weakening without significant overall economic deterioration, investors became increasingly optimistic that the economy would endure a “soft landing” as inflation moderates.  Unemployment has ticked slightly higher, but still remains pretty low, at 3.8%, but the Fed predicts it will rise to 4.1% next year.  Consumer spending has also remained robust, yet borrowers are starting to carry higher loan balances.  For these reasons, despite some continued economic strength, doubts began to emerge in the third quarter that the economy would experience a soft landing, while the Fed indicated that interest rates would stay high for longer than expected and at least one more interest rate hike would likely occur in 2023.  The higher that the Fed anticipates raising interest rates, the more likely the economy will suffer more in an effort to corral inflation. 

            While we believe the economy will not suffer a significant recession as a byproduct of bringing inflation under control through higher interest rates, we also feel that markets were over-pricing the likelihood of the Fed shifting its stance on interest rates to a more dovish tone.  For much of 2023, fed fund futures markets indicated expectations of a relatively abrupt shift in Fed policy towards pausing rate hikes and then cutting rates in 2024.  This expectation caused equities to rally, as lower interest rates would increase valuations across asset classes, including equities. Yet, throughout the Fed’s interest rate hike campaign of the past 18 months, markets have been underestimating the Fed’s resolve in breaking inflation, as every Fed announcement has seemed more hawkish in tone than markets expected.  As discussed below, while inflation has moderated significantly from its high in June of 2022, it is still higher than the Fed’s target of 2% annualized.  The Fed also has indicated that it is far more concerned with not going far enough to bring inflation down and then needing to raise rates at a later date much more aggressively.  It would rather overshoot on higher interest rates now and cut rates later if needed than stop raising rates now and have to restart rate hikes after inflation picks back up again.  Fed Chair Powell has spoken numerous times about not repeating this mistake, which was made in the 1980s and led to a prolonged inflation battle then.  As we’ve noted in prior market commentaries, we are very close to the end of the Fed interest rate hikes, but in the third quarter, investors may have gotten too optimistic as to how quickly the Fed would shift its policy stance.

            On the inflation front, progress has been made, despite rising energy prices.  Year-over-year CPI has fallen to 3-4% over the past several months, from the high of 9% in June 2022.  This downward trend has continued despite rising oil prices recently, with WTI crude rising from $60-$66 per barrel in June 2023 to ~ $90 per barrel today.  Nevertheless, the Fed’s stated goal is to bring inflation down to 2% through monetary policy and the trend has been headed in that direction for some time.  As we’ve discussed in prior commentaries, under the hood of the CPI number are factors that indicate that inflation data will continue to show inflation slowing, including, most notably, shelter prices, which are calculated in part based on rents that take an extended time to reflect price changes due to leasing that locks in rent prices for a period of time.  Since monetary policy changes take effect with long and variable lags, we expect the real impact of the Fed’s interest rate hikes to lead to further slowing of inflation over time.

Commercial Real Estate Weakness Implications

            The commercial real estate market, particularly in office properties, is an area of concern that could lead to broader economic weakness.  Commercial real estate has likely been the most impacted area of the economy by higher interest rates, and this is compounded by the sticky prevalence of remote work in the pandemic aftermath.  Historically, Fed rate hike cycles persist until something breaks in the economy.  It seemed that the regional bank weakness earlier in 2023 might have been the impetus for a pivot in Fed policy, however that crisis has subsided somewhat with the failures of a handful of banks that were particularly poorly positioned for higher interest rates.  However, the commercial real estate market is now a focus of attention, as owner borrowers seek to refinance loans coming due in a substantially higher interest rate environment and with rent rolls on the decline due to less demand for office space from tenants.  Approximately $1.5 trillion in commercial real estate debt will come due prior to 2025, 25% of which is in office real estate.  With refinancing options unattractive at higher rates and with rent rolls reduced due to lower tenant demand, many borrowers are going to be left with undesirable options.  Higher interest rates also means that property values in the sector have been hit hard, with few buyers that feel the market has hit bottom and many banks that lend in this area are regional banks that were previously hit with deposit outflows in 2023.  However, the commercial real estate market is quite large, and few lenders will want to take over properties in default, so it’s unlikely that this crisis will spiral into broader economic calamity.  Further, it’s possible that interest rates will start to come down over the next 1-2 years, which would give borrowers more breathing room to refinance.  Nevertheless, the commercial real estate sector will likely endure a prolonged contraction and the sector bears watching as one of the most impacted areas of the economy from higher rates.