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The Brave Report: Market Commentary for Q3 2023

How high will they go?…. Rates continued their historic climb over the past quarter, and it is now expected that rates will remain high throughout 2024. The larger question that remains is when will these elevated rates start to bite the economy.  So far, the economy has remained resilient in the face of these elevated rates, but I fear there will be a point where the holes in the economy are impossible to ignore. By that time the Fed will have backed itself into a corner with little ability to get the economy going again.

There will still be winners in this scenario, but investors will need to be selective in where they park their money. In the meantime, these elevated rates on treasuries should be taken advantage of while we wait for more economic data to filter through.

Market Overview

After a strong first two quarters of the year, markets took a step back in the third quarter. All three major indices lost ground over the last three months with the S&P 500, NASDAQ and Dow down 3.6%, 4.1% and 2.6% respectively. Rapidly rising rates, recession fears and geopolitical uncertainty all weighed on stocks. Investors took some risk off as we saw large inflows into treasuries. However, even with the rising rates, labor markets have remained resilient and while corporate earnings dropped, they still outperformed expectations.  At some point, we will see the impacts of the higher rate environment on the overall economy, but that impact has been muted so far and has only been visible in some areas of the economy.

The fixed-income side of things has been the driving force behind markets in recent months.  We saw continued rapid jumps in rates across the yield curve. The 10-year treasury closed out the quarter with a yield just below 4.7%, its highest level since 2007.  More than just the current level has been the speed of the rise.  As recently as May, the yield was around 3.2%.  On the shorter end of the curve, we have seen the yield stay above 5% on everything from the 1-month to the 2-year treasury.  Because of this, there has been a rapid increase in short-term treasury exposure as investors continue to be comfortable earning 5% while they wait for the equity markets to show some more conviction in their directionality.

Downward pressure on bond prices picked up steam during the third quarter. These rapidly rising rates put pressure on stocks amid fears that inflation is stickier than most thought and that the Fed will be forced to raise rates again before year’s end. The Fed has slowed its pace of increases, but it is now feared that this environment of elevated rates will be around for longer than many expected.  The most recent Fed “dot-plot” illustrated a higher expected rate throughout 2024.

The big issue we are seeing is that this rise in interest rates has yet to fully bite the economy. Economic data has continued to come out stronger than expected.  The consumer has remained resilient in the face of rising rates, and the labor market has remained strong.  Unemployment still sits below 4% and we continue to see job growth.  The Fed watches these labor numbers closely, as one of their mandates is full employment. While job growth has slowed slightly, we have yet to see elevated interest rates have the desired impact on the labor market.

The difficult thing investors are dealing with is that rate increases tend to have a lagging impact on the economy.  Increased rates don’t have a short-term impact but at some point, the scales are tipped and you see these rates start to have a measurable effect on the consumer and the labor market.  The fear is by the time they start hurting the economy, they will already have been raised too far and the Fed will struggle to right the ship. I do think some of this negative economic impact is already priced in but if we see a measurable pullback in consumer spending, the entire economy will be impacted, and we will see some softness in the markets.

The Fed has also been working to bring down inflation. They have been successful in doing so, to a point, but inflation has remained elevated above long-term norms.  Like the labor market, the question remains as to how much damage the Fed will have to do to the economy before inflation drops back toward its target rate.

The Fed is trying to slow the economy to combat inflation but so far, the economy has been resilient to the elevated rate environment in most areas. Corporate results last quarter were stronger than expected and while earnings did retract slightly, they still outperformed expectations.  What we have seen in the corporate world is that there has been some weakened demand in some areas but larger companies, especially on the tech side, have continued to produce record cash flows.  These companies represent such a large percentage of the overall corporate earnings picture that they have been able to mask some of the holes in the economy. This bifurcated economy has made it difficult to get a full picture of how well companies are doing and I think it would be naïve to think that elevated rates won’t have an impact at some point, especially on companies that need to raise debt or rely on revolving lines of credit.  The winners will continue to be those companies that can produce consistent cash flow.

One of the areas where we are starting to see holes and that I fear could be the first place we see some major issues is in the commercial real estate sector, especially when it comes to office space.  Increased vacancies combined with increased financing costs will make the current model difficult to sustain.  The problem is that issues with these large commercial loans could spill over to the banking sector as they hold and repackage much of this debt.  While I don’t think this will ripple through all sectors of the economy it is something I will be watching closely going out into next year.

Strategy Commentary

Over the past quarter, I have continued to maintain a neutral to cautious positioning across most allocations.  Rising rates along with the other uncertainties that I have discussed have presented a market environment where the risk is to the downside.  I have refrained from adding to my equity positions besides some basic rebalancing.  I am currently comfortable increasing exposure to treasuries, mostly on the short end of the curve until we see some stabilization of rates.  While I have not been buying much equity, some of the recent pullbacks have brought a few names and sectors back into a “buy” range. I will be quick to add to some of these positions should economic and corporate data warrant.  As discussed, there are still some areas of the economy that are holding up, even with higher rates.  These will be the winners if we do see a softer landing for the economy because they provide equity exposure with reduced risk.

Domestically, I am maintaining increased exposure to large technology and communication services stocks.  Growth and technology names tend to be more sensitive to rising interest rates, but we saw during the most recent earnings period that these names have held up better in the current economic environment.  I am still avoiding the more speculative names and focusing primarily on those large tech names that have strong balance sheets and robust cash flow.  These “growth” names are now seen as a safety trade and a good place to park money during times of uncertainty.

Similarly, on the international side, I am also focused on large, developed names.  Geo-political uncertainty, both in Ukraine and the Middle East has led to an environment where any increased international exposure should be done cautiously.  I continue to like the longer-term story in India but am in no rush to add exposure.  Should the geo-political landscape improve, I will again look to increase exposure here.

On the fixed income side, I have continued to add exposure, especially on the shorter end of the curve. Rates have continued to rise rapidly over the past quarter and this has provided the opportunity to park excess cash in these high-yielding treasuries.  I have also started to look at some higher-quality municipal exposure for taxable accounts.  The current after-tax yields are becoming difficult to ignore. When we get to a point where it looks like rates are peaking, I will start to move out on the curve to get a larger benefit from dropping rates. Going into year-end, I will also be looking to tax loss harvest in any of my existing long-dated exposure as the prices have dropped quickly in the rising rate environment and can help provide a tax balance to the equity gains from the first half of the year.

Click here for .pdf version of this report: The Brave Report-2023Q3

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