Market Insights: Third Quarter 2023

Higher Interest Rates Weigh on Stocks

Volatility returned to markets during the third quarter. The S&P 500 declined towards the end of the month to hit a fresh three-month low as rising bond yields pressured stock valuations and fears resurfaced about a possible bounce back in inflation. 

The S&P 500 started the third quarter with gains thanks primarily to “Goldilocks” economic data, meaning the data showed solid economic growth but not to the extent that would have implied the Federal Reserve needed to hike rates further than investors expected. Stock prices got an additional boost from reduced near-term recession risks and a steady decline in inflation metrics. The Federal Reserve, meanwhile, increased interest rates in late July but also signaled that could be the last rate hike of the cycle. That tone and commentary fueled optimism that one of the most aggressive rate hike cycles in history was soon coming to an end. 

However, the market dynamic changed dramatically in August. Yields on U.S. Treasuries soared to levels not seen since the mid 2000s. Stock prices declined throughout the month as higher rates pressured equity valuations and raised concerns about a future economic slowdown. 

The August volatility subsided briefly in early September as solid economic data and a pause in the rise in Treasury yields allowed stocks to stabilize. But that didn’t last long as volatility returned in the second half of the month, following the September Fed decision. Markets were delivered a “hawkish” surprise, despite interest rates not being increased. Specifically, the majority of Fed members reiterated that they anticipated the need for an additional rate hike before the end of the year and forecasted only two rate cuts for all of 2024, down from four rate cuts forecasted at the June meeting. 

Markets begin the fourth quarter decidedly more anxious than they started the third quarter, but it’s important to realize that while the S&P 500 did hit multi-month lows in September and there are legitimate risks to the outlook, underlying fundamentals remain generally strong.

First, while there are reasonable concerns about a future economic slowdown, the latest data remains solid. Employment, consumer spending and business investment were all resilient in the third quarter and there simply isn’t much actual economic data that points to an imminent slowdown. So, while a future economic slowdown is certainly possible in this higher interest rate environment, it isn't happening yet.

Second, fears that inflation may bounce back are also legitimate, given the rally in oil prices in the third quarter. But the Federal Reserve and other central banks typically look past commodity-driven inflation and instead focus on “core” inflation and that metric continued to decline throughout the third quarter. Also, declines in housing prices from the recent peak are only now beginning to work into the official inflation statistics, and that should help core inflation continue to move lower in the months and quarters ahead.

Finally, regarding monetary policy, the Federal Reserve’s historic rate hike campaign is nearing its end. And while we should expect the Fed to keep rates “higher for longer,” high interest rates do not automatically result in an economic slowdown. Interest rates have merely returned to levels that were typical in the 1990s and early 2000s, before the financial crisis, and the economy performed well during those periods. Yes, the risk of higher rates causing a slowdown is one that must be monitored closely, but for now, higher rates are not causing a material loss of economic momentum.

The Primoris Wealth Advisors Team