Following a strong first half of 2023, third quarter returns were more challenged across almost all asset classes. One outlier was high-yield debt, which often serves as a way to de-risk equity exposures when stocks are under pressure. Most year-to-date returns remain in positive territory, yet a closer look at equities during the third quarter reveals a story of different chapters.
Strong returns in July were driven by a continued decline in inflation and strong earnings reports from mega-caps, such as Netflix and Tesla. In August, investors became concerned over fears of hotter-than-expected economic growth and what that might mean for the future path of fed rate hikes. After some healing in late August, the markets segued into what is often the cruelest of months, September, when stocks sold off sharply as yields on 10-year US Treasury notes continued their advance.
The combination of a stronger-than-expected economy and inflation rates that remain above the Fed’s long-term target makes one thing clear: rate cuts on the part of the Fed will probably happen much later than what many believed at the beginning of this year.
Despite lower prices in areas such as food and durable goods, services prices have remained a bit stickier. And services – ranging from items such as car insurance to concert tickets – are a significant part of the economy.
This has led to conflicting signals as it pertains to the consumer. The combination of a tight labor market and inflation well off from its peak has boosted take-home pay. However, excess savings that had been accumulating during the COVID pandemic are now heading back down to their long-term trend.
That combined with credit card interest rates jumping over 40% in just the last two years may act as strong headwinds against consumer spending, which makes up the majority of many economies.
So this is a key factor that has led to our lower forecast of economic growth for many regions. That said, we expect inflation to moderate into next year, and this should allow central banks to begin easing rates. Despite the more challenging returns in the period, opportunities remain among equity and fixed-income markets. And although our base case does not call for a recession, the absence of a recession is not the presence of a recovery.
That’s why we continue to emphasize a quality approach to equity investing. One provocative area is healthcare – especially considering the uptick in elective procedures. For example, the projected growth for specialized heart valve replacements is expected to double this decade.
Another area of quality equities are select dividend-paying stocks. Among their attributes, they provide a rising stream of income over time, as these companies’ free cash flow is expected to grow at a rate above inflation. This contrasts markedly with a favorite investment strategy: cash.
Cash looks attractive now, but our expectation of a lower fed funds rate over time would ultimately lead to lower yields on cash equivalent investments. Staying too long in cash if yields do decline would lead to missing out on the potential for increasing dividends and stocks that might appreciate along the way.
But return opportunities are not exclusive to equities – considering the higher yield environment that has enhanced the return potential for fixed-income investors. One area that continues to look appealing is US high yield, where the current yield to worst is roughly 9%, a yield that is near a 10-year high.
And bonds we find most attractive are those with credit ratings of single B or better. We believe caution is necessary when exploring CCC bonds given their less favorable risk/reward history. Further, the overall health of the high-yield market has improved considering that only 10% of existing bonds will need to be refinanced in the next two years, which lowers the risk of issuers having to refinance at rates that could remain expensive. Additionally, while there’s typically a higher default rate risk with CCC credits, only a very small portion of that 10% of high yield bonds coming due in this two-year window have this lower credit rating.
During this time of resistance, to the path of normalization, we feel well-researched opportunities will lead to favorable outcomes for patient investors. All the best, and we will see you next quarter.