2023 Q4 Market Outlook
Somehow, we are already moving into the 4th quarter of 2023. We are looking ahead at the rapidly approaching holidays and gearing up for 2024. But before we get ahead of ourselves, a looming question remains in the markets: Is this bear market going into hibernation?
To back up a little bit, in July, the US stock market was up much more than many expected and we saw US market indices, including the S&P, Dow, and NASDAQ, up near double digit returns at that time. You may also recall that we were suggesting a pullback was very likely and expected a bit of a stall. As it turns out, our last Market Outlook was written near the height of the market this year. Since July, we have seen a pullback, followed by a sideways trend as the markets try to determine where to go from here. That begs the question: where do the markets go next as we look ahead to the end of the year and into 2024?
Risks Ahead: The Fed and a Potential Recession
Likely, the reason we have seen this kind of pullback lately is due to early signs of a slowing economy. More importantly, the Fed has changed their tone regarding their expectations around inflation and interest rates. In fact, in the last meeting, Federal Reserve Chair Powell had shared that they expect another rate hike through the end of this year. Additionally, it is now becoming more evident that interest rates may stay higher for longer. While the consensus was that rates may drop early in 2024, we believe the Fed may take longer than expected to begin decreasing rates. If and when the Fed does blink, we may see a shift in the markets. That said, we are not there yet. With inflation dropping from 8% to 4%, many may suggest we have realized a victory. Inflation dropping from 4% to the Fed’s 2% target, however, is likely to be a tougher road ahead and may take longer than many are forecasting.
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When it comes to the “R word” of 2022, recession, there has been much speculation over the past 18 months. At this time last year, there was quite a lot of media buzz on the topic of a potential recession. Over time, the media focus has shifted and is now suggesting we will see a “soft landing”, all but dismissing the recession discussions from 2022. However, it is important to know that a typical recession takes some time to be realized. One of the leading indicators of a recession is what’s referred to as an inverted yield curve. An inverted yield curve refers to the phenomenon where short term interest rates are higher than long term rates. For example, if you were to look at a ten-year bond versus a shorter term, such as two-year bond, typically the yield you would realize for a 10-year bond is higher than the yield you would realize for a short-term investment. To help put this in perspective, if you're giving your money away for a longer period, you would typically expect more in return.
What we saw in 2022 was quite the opposite, and we were paid more to hold short-term bonds than to take the risk of holding longer-term bonds. Those who did hold long term bonds saw a big hit to the “safe” part of their portfolio, their bond exposure. To be clear, a yield curve inversion does not alone suggest that a recession is coming. However, since that was the catalyst for these recession talks previously, I want to point out that the average time, between the yield curve inverting and experiencing a recession is long. The mean number of days from yield curve inversion to a recession is well over a year.
Today, in October of 2023, we are still well under the average timeframe, whether you evaluate mean or median days. This time frame doesn't mean that a recession is coming or that we know one is going to happen. However, it is important to put this into perspective as the media shifts its focus away from the recession story as more time goes by. Ultimately, we do still feel a recession is slightly more likely to happen than not. However, the good news is that we are likely much closer to clarity than we have been through the entire 18 months or so that we have been experiencing this market volatility.
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Looking Ahead
Last quarter, we at Mainsail were concerned about a potential, shorter-term pullback in the markets but were becoming more optimistic about the longer term. It's not that we don't think there are challenges ahead, but rather, this optimism comes from the idea that we are likely much closer to understanding the impacts of these challenges than we were a year ago. Once we have clarity around a recession’s likelihood, we will be able to pivot, with actual data, based on where the markets are heading. Soon, perhaps by the end of the year or in early 2024, we will have a better idea if we are in a recession and can finally put this behind us.
As we gear up for this signal, we must look at opportunities in a risk-return dynamic. We want to ensure that we evaluate the risk-reward of everything we do in case this recent volatility continues. For example, cash is finally paying a strong interest rate, so cash equivalents may be a great place to hold a portion of our assets until we have a sense of direction. The challenge is that markets change quickly; if we see the markets start to pick up, we need to ensure we have some exposure to the stocks that will allow us to experience these potential gains. The key is to have some defense in place, whether that is through cash, commodities, more defensive equity positions, or all the above. This way, if the market does shift quickly, we have the flexibility to take advantage of that opportunity and move quickly.
In the shorter term, it is likely we do see continued volatility. Signs of a brighter future are on the horizon, however we just may not be there quite yet. It is easy to get caught up in the excitement as markets begun to pick up in 2024. But don’t get caught in the bear trap! This euphoria is all too common during challenging economic cycles and a proper risk-reward approach will allow you to be paid to be patient, provide opportunity to act when things shift, and protect your downside if we do experience more short-term volatility. If you have questions or would like to discuss your risk profile in your investments today, please reach out to us and we would be happy to evaluate the strength of your current portfolio.