2023 4th Quarter Investment BUlletin
Executive Summary
Stock Market Decline: The quarter began on a positive note but experienced a downturn in August and September, resulting in the first quarterly decline in 2023.
Rising Interest Rates: Concurrently with the decline in stocks, there was a notable increase in interest rates, particularly for longer-term bonds. The 10-year Treasury rate surged from 3.8% in late July to 4.6% by the end of the quarter. This rise in rates can have significant implications for various aspects of the financial markets.
Impact of Higher Interest Rates: Higher interest rates have both positive and negative effects. On the positive side, they make conservative investments like money markets, certificates of deposit (CDs), and Treasury bonds more appealing to investors, offering higher returns than they have in a decade or more. However, on the downside, higher interest rates can dampen economic activity, as seen in sectors like housing, automobile sales, and durable goods purchases, which are sensitive to changes in interest rates.
Bonds Performance: One of the consequences of higher interest rates is a decrease in the price of existing bonds. This has had a significant impact on bond funds, leading to steep losses in the previous year and resulting in little to no growth in bond funds in 2023.
Interest Rate Activity
Federal Funds Rate vs. 10-Year Treasury Rate: The chart below illustrates the movement of two crucial interest rates: the Federal Funds Rate (purple line) and the 10-Year Treasury Rate (orange line). The Federal Funds Rate, controlled directly by the Federal Reserve (FED), saw significant increases starting in early 2022.
Inverted Yield Curve: The rapid rise in the Federal Funds Rate resulted in an "inverted" yield curve, where short-term interest rates surpassed long-term rates. This inversion has persisted since mid-2022. An inverted yield curve is often seen as a potential signal of an economic slowdown or recession, as it suggests investor expectations of lower future interest rates.
Recent Rate Trends: In August and September of 2023, there was a noteworthy acceleration in longer-term interest rates, along with a flattening of short-term rates. This suggests a shift in interest rate dynamics during those months.
Implications for Investors:
Conservative Investors: The increase in longer-term Treasury bond and CD rates, exceeding 4.5%, has made these investments more attractive for conservative investors seeking stable returns. These higher rates provide an appealing option for those looking to preserve capital and generate income.
Growth-Oriented Investors: Rising interest rates can make bond funds more appealing for growth-oriented investors. Higher rates lead to increased monthly interest payments from bonds, potentially boosting overall returns. Additionally, if the Federal Reserve begins cutting rates in the future, the price of existing bonds can rise, offering potential capital appreciation.
Stock Market Concentration
Concentration in Large-Cap Growth Stocks: In 2023, the stock market saw significant gains primarily driven by large-cap growth stocks. This means that a select group of established, often technology-oriented companies with strong growth potential outperformed other segments of the market.
Long-Term View: When considering a longer time frame, such as the three-year period dating back to October 2020, the importance of diversification becomes more evident. Diversification involves spreading investments across various asset classes, sectors, and regions to reduce risk. Over this extended period, different segments of the market may have outperformed at different times, and a diversified portfolio can help balance these fluctuations.
Benefits of Diversification:
Risk Mitigation: Diversification helps mitigate risk by reducing the impact of poor performance in any single asset or sector. When one segment of the market underperforms, others may compensate, helping to stabilize overall portfolio returns.
Capitalizing on Opportunities: Diversification allows investors to participate in various investment opportunities. For example, while large-cap growth stocks may dominate in one-year, other asset classes like small-cap stocks, value stocks, or international equities may shine in different market conditions.
Long-Term Growth: By diversifying across asset classes, investors can benefit from long-term growth trends in different areas of the market. This can result in more consistent, sustainable returns over time.
Outlook & Positioning
Despite the likelihood of slower economic growth because of higher interest rates, the stock market does not seem to be overvalued. Stock prices are still lower than where they began in 2022, but earnings have not declined during the last 21 months. Overall, the stock market appears to be fairly valued, and possibly undervalued following the recent declines. It may take some time to fully realize this favorable position because of the various economic headwinds, but remaining invested in stocks is a good risk/reward proposition at present.
Further, the bond market will begin to benefit from higher interest payments and will have a tailwind should interest rates decline in the next year or two. Lastly, the allocations we’ve made to the option-based Innovator and Allianz investments have served their purpose well. The investments provide lower volatility than stocks and material downside protection in the event we suffer a repeat of 2022, while at the same time providing market upside up to approximately 14%.