Endowus Q3 2023 Market Update and Outlook — Can Fixed Income be fixed?

Higher for longer

The quarter closed with the Federal Reserve announcing a pause on rate hikes in September, leaving the federal funds rate target range unchanged at 5.25% - 5.50%. This pause was to allow more time for the impact of previous rate hikes to flow through the economy. Even then, the Fed had maintained its stance on “higher-for-longer”, indicating that interest rate cuts were unlikely to occur before late 2024.

The Federal Open Market Committee (FOMC) “dot plot¹” released in the September FOMC minutes indicates one more rate hike coming before the end of the year. This suggests that economic conditions or inflation concerns remained on their radar, motivating them to advocate for continued tightening of monetary policy.

The outlook for 2024 is equally noteworthy, as the dots on the plot suggested a period of sustained higher interest rates in that year, keeping consistent with the higher-for-longer rhetoric from the Fed.

¹ The Federal Reserve's "dot plot" is a tool that offers insight into the Federal Open Market Committee's (FOMC) members' views on future monetary policy. It visually represents FOMC members' individual projections for the federal funds rate. The September release indicated that some members anticipated one more rate hike before the year's end.

The markets had been nervous since August and reacted negatively to the relatively hawkish tone from the September meeting; long-term treasury yields rose and equity returns took a nosedive. Emerging markets, surprisingly, held up better than developed markets in September.

Will fixed income recover?

Investors seeking safety in fixed income this year would have been disappointed by the meagre to flat returns returned by the broad fixed income market (as represented by the Bloomberg Global Aggregate Index (Hedged)). In HKD terms, the return in the first three quarters of the year was 0.11% and in USD terms, it was slightly better at 1.09%. However, one must not forget that the yields are at the highest they have ever been for decades. As long-term investors, it might be worthwhile staying invested in fixed income while enjoying the yields.

Yields for cash and money market instruments have also risen along with their longer duration peers, and this has led many investors to forsake longer-dated bonds for the security and liquidity of treasury bills and money market funds. While this may seem wise in the current environment, as a long-term investor, it is worth considering taking on additional duration risk.

While the “higher for longer” narrative may continue to drive fixed income and equity markets, the chart above shows that in flat or falling interest rate periods, bonds (as represented by the Bloomberg 1 - 5 Yr Gov/Credit TR index) have typically outperformed 3-month Treasury bills.

It's hard to predict how long the Fed will keep interest rates high, but when the economy starts to deteriorate, interest rates are likely to drop. If an investor is mainly invested in short-term investments like 3-month US Treasury Bills, there is a chance that he/she might have to reinvest his/her money at lower interest rates later on. This risk of having to reinvest at lower rates is higher now because interest rates are at their highest level over the last 10 years.

What this means is that investing in high quality bonds will allow investors to lock in the higher yields for a longer time. Additionally, this presents an opportunity for capital appreciation if interest rates are cut during an economic downturn.

Q3 2023 market update

Global equity market 

After a robust start to the year, with strong gains in the first half and growing optimism about a “soft landing”, markets faced turbulence, with negative returns and rising government bond yields sending shockwaves through various sectors.

Q3 also saw growth stocks underperform their value peers although in the year-to-date period, the MSCI ACWI Growth Index is still up more than 15% relative to the MSCI ACWI Value Index. As for the size factor, small cap stocks in the emerging markets had a surprisingly robust quarter, returning nearly 3%. In contrast, EM large cap stocks declined by about the same quantum. The difference is even more stark for the year-to-date period; with the MSCI EM Small Index up about 13.7% while the MSCI EM Index was up by 1.8%. Small caps also outpaced their large cap peers in the developed markets, albeit by a much smaller margin. Notably, the United States was an outlier, with US small caps underperforming US large caps by about 1.8%.‍

US equity market woes and the Tech conundrum

The US experienced a weakening in its equity market during Q3. Optimism among investors that the Federal Reserve's tightening measures were nearing their end waned as August and September unfolded with the looming potential of prolonged higher interest rates.  This particularly impacted the IT sector, with the “magnificent seven” declining after headline performance in the first half of 2023. As the major US indices have become more concentrated in recent years, these tech companies continue to wield an outsized influence on market returns.

Europe’s rocky road: Searching for Stability Amid Economic Uncertainty

Europe was one of the worst performing regions in the third quarter as it continued to face a myriad of problems. The MSCI Europe Index retracted nearly 5% for the quarter in USD terms, reflecting the growing anxiety around interest rate hikes and their potential impact on the European economy. However, there was a glimmer of hope as eurozone inflation showed signs of slowing down, sparking optimism that the European Central Bank (ECB) might reconsider its stance on interest rates.  Similar to the US, the energy sector outperformed other sectors, but the consumer discretionary sector declined sharply.  One outlier in Europe was the UK where equities saw a rise during the quarter, with energy and basic materials rebounding from previous weakness.  Domestic consumer confidence rose as well, with the hope that interest rates may have peaked.

Emerging Markets: A Mixed Bag in Asia and Beyond

The third quarter of the year witnessed a rollercoaster ride in emerging markets, particularly in Asia. The initial optimism quickly fizzled out, leaving the region to end the quarter on a negative note. However, the MSCI EM Index managed to outperform its developed markets peer, MSCI World Index, by about 0.50%.  China was one of the largest concerns, with disappointing economic news and a weak property sector.  Taiwan and South Korea also saw declines, while Malaysia and India exhibited positive performance.

Global fixed income market

The global fixed income market saw a series of significant developments in the third quarter, sparking concerns and raising questions about the future of fixed income investments.

The headline news in Q3 was the downgrade of the US by Fitch from triple A to double A plus, and as if to confirm that, since then, the world has observed renewed brinkmanship around the country’s debt ceiling and additional political discord in the House. Aside from that, the fight against inflation continues to be the central theme.  Bond prices declined in most developed markets as the realisation set in that rates may remain “higher for longer”. This continued a recent pattern of positive correlations between equity and bond markets.

The yield curve stayed inverted even though the slope had become less steep since its peak in the first half of the year. And, while corporate bonds did better than government bonds, credit spreads were tight. The only major bond sectors with positive performance were EUR and US high yield, particularly those with short durations. The high yield, more risky segment of the bond market also fared better than its higher quality brethren.

Commodities and gold

The S&P GSCI index returned more than 15% (USD terms) in the third quarter, largely driven by the increase in crude oil and energy prices. The S&P GSCI Crude Oil rose more than 30% in Q3 with the S&P GSCI Energy following suit with a 28% increase. Both Russia and Saudi Arabia reaffirmed their commitment to supply cuts, driving a surge in oil prices.  Conversely, natural gas declined mostly due to oversupply and waning demand.  With the oil price single-handedly driving commodity index rises, most other commodities had modestly positive or negative returns.

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