Quarterly market outlook - fourth quarter 2023

Asset class performance

Looking back at the 3rd quarter

Monetary policy remained center stage in Q3. A spike in yields drove equity markets lower, while fixed-income returns were mixed.

Fed projections drive yields higher, stocks and bonds lower

The Federal Reserve hiked interest rates by 0.25% in July but held rates steady in September. In September’s meeting, the Fed also projected 0.5% of rate cuts in 2024, versus prior expectations of 1%. Policy rate expectations for the end of 2025 were also 0.5% higher than previous estimates.

Encouragingly, the higher rate expectations were accompanied by stronger expectations for economic growth and tighter labor market conditions, not an increase in inflation expectations. Markets responded with yields rising to new cycle highs and declines to equities and investment-grade bonds.

Treasury yields reach highest levels in over 15 years

Treasury yields moved higher in Q3 in response to stronger expectations for economic growth and the Fed’s higher policy rate projections. The 10-year Treasury yield rose to over 4.6%, the highest level since 2007, while the two-year yield rose to over 5.1%, the highest level since 2006.

Equity markets declined in response, with the real estate and utilities sectors the worst performers. Fixed-income markets — especially investment-grade bonds — followed suit, moving broadly lower.

Oil prices rise over 25%

Oil prices rose to over $90 a barrel during Q3 in response to the OPEC+ announcement of extended production cuts through year-end. The surge in oil prices boosted returns for energy stocks, with the sector returning over 12% in the quarter.

Higher energy prices flowed into inflation data, with headline CPI rising 3.7% year over year in August, above a 3.2% rise in July. Encouragingly, core CPI (excluding food and energy) continued to trend lower, registering a 4.3% year-over-year rise, the lowest reading since September 2021.

Action for investors

The recent spike in volatility is a reminder to maintain global diversification across portfolios. Over the past 12 months, developed international large-cap stocks have outperformed U.S. large-cap stocks. Work with your financial advisor to ensure your portfolio is appropriately diversified and aligned with your long-term goals.

Economic outlook

The U.S. economy has been remarkably resilient through the first three quarters of this year. GDP growth has averaged above 2% annualized in 2023 thus far, which remains above long-term trend growth.

Households have benefited from higher levels of savings post-pandemic and a solid job market, leading to stronger consumption patterns overall. However, we would anticipate some softening in the months ahead.

The labor market may cool

The labor market has started to show some early signs of easing. While the unemployment rate remains healthy at under 4%, leading indicators such as job openings and quits rates are declining, while labor force participation (workers reentering the workforce) has increased. This may spur some softening in the tight labor market and continue to put downward pressure on wage gains.  

The consumer may come under some pressure

Keep an eye on the U.S. consumer. While the consumer has remained resilient, we’re seeing household excess savings being drawn down and credit card debt levels rising. This comes amid elevated interest rates, rising oil and energy prices and tighter bank lending.

Near-term overhangs include the United Auto Workers (UAW) strikes and resumption of student loan payments. These could add uncertainty and weigh on consumption — particularly services consumption — going forward.

Expect some softening in economic growth

While we do not expect a deep or prolonged economic downturn, we could see a couple of quarters of below-trend GDP growth, given the potential easing in the labor market and consumption.

This is in line with the view of a “rolling recession,” where some parts of the economy, such as manufacturing, may be bottoming and stabilizing, while other parts, such as services consumption, may just be starting to cool.

Action for investors

We recommend staying neutral in U.S. equities and bonds, relative to your long-term strategic asset allocations. We would expect opportunities to emerge in both equities and bonds as the economy recovers from a potential period of softness.

Equity outlook

High interest rates on the back of a determined Federal Reserve took some wind out of the market’s sails in Q3. However, moderating inflation, recovering corporate profits, and an approaching end to the Fed’s rate hikes can support a positive outlook for the remainder of the year, especially for parts of the equity market that have lagged.

Earnings recovery provides support

Higher material and labor costs have pressured corporate profits, with S&P 500 earnings down about 8% from last year’s peak. But this decline was not as bad as feared, since corporate revenue has continued to grow, driven by a resilient economy.

After three consecutive quarters of declines, Q3 results will likely mark a positive inflection point, with earnings poised to increase from a year ago. We expect earnings to rebound further in 2024, validating the broader uptrend in stocks.

High interest rates pose valuation headwinds

Valuations for U.S. large-cap stocks have increased over the past year, driven primarily by mega-cap tech stocks, which have benefited from enthusiasm around artificial intelligence (AI).

With interest rates likely staying higher for longer, valuations might have a hard time expanding further. This is why we think earnings growth will have to do the heavy lifting to drive markets

Opportunities might lie beneath the surface

Outside mega-cap tech, valuations are more reasonable, presenting an opportunity for sector leadership to broaden over time.

The S&P 500, which is heavily influenced by the 10 largest companies based on market capitalization, has gained about 12% since the start of the year. But the S&P 500 Equal Weight Index, which assigns the same weight to all the stocks that are included, has stayed flat for the year, highlighting the narrow participation.

Other lagging segments of the equity market include small-cap stocks and value-style investments, both of which have the potential to catch up.

Action for investors

We recommend a neutral allocation in equities, staying close to your long-term strategic allocations and using pullbacks to diversify across lagging asset classes. We favor increased allocations within consumer discretionary and reduced allocations to financials.

Fixed income outlook

Yields have risen substantially in recent months, weighing on the U.S. bond market. The two-year and 10-year Treasury yields have risen to highs of the cycle, putting near-term pressure on both stocks and bonds.

The Fed signals higher for longer

In September, the message from Federal Reserve Chair Jerome Powell was clear: The Fed will keep rates elevated until inflation moves more convincingly toward 2%.

The Fed held rates at 5.25% to 5.5% but kept the option of another rate hike, maintaining its outlook for a peak fed funds rate of 5.6%. The Fed also signaled fewer potential rate cuts in 2024 — from 1% to 0.5% of cuts — implying higher interest rates may last longer than expected.

Fewer rate hikes and no cuts on the horizon

In our view, while Powell and team may indicate they’re not done raising rates, several factors may keep them on the sidelines. Inflation — especially core inflation — continues to gradually move lower, and the labor market has shown early signs of cooling. Also, the consumer, which has been the backbone of the economy, faces higher gas prices while drawing down excess savings.

While the Fed may be nearly finished with rate hikes, we would not expect rate cuts until 2024. In the absence of a deep or prolonged downturn, we would expect the Fed to gradually bring rates back toward a neutral level, which may be around 2.5% to 3%.

Balance cash with longer-term bonds

While short-duration cash-like instruments are offering 5%+ yields, being too overweight in cash could come with reinvestment risk as the Fed pivots lower over time. We see attractive opportunities forming in longer-duration investment-grade bonds.

Historically, one of the best predictors of forward bond returns is current yields. If the Fed indicates it’s close to a peak interest rate, this could be a favorable time for high-quality bonds. Not only can you lock in better rates for longer, but they have the chance for price appreciation if and when the Fed pivots lower.

Action for investors

We recommend remaining neutral in fixed income relative to your long-term strategic asset allocations. Avoid being too overweight in cash-like assets, and consider complementing these with longer-duration bonds over time.

International outlook

While global growth is slowing, inflation is moderating, allowing central banks to pause. The U.S. economy has stayed resilient in the face of high borrowing costs, but its equity market is becoming increasingly concentrated. With this narrow market leadership, international diversification may help reduce portfolio volatility.

Major economies move at different speeds

A unique feature of the post-pandemic economy has been the disparate and uneven growth trends across regions. Japan’s economy has surprised to the upside this year, driven by strong corporate spending, robust exports and market-friendly regulatory reforms. With its equity market attracting foreign investors and still trading at low valuations, this year’s outperformance could continue.

In China, growth has disappointed as the property market deteriorated, but policymakers have announced measures to support it. We expect more volatility, but the stimulus efforts could lead to a stabilization ahead.

Although Europe has avoided a recession, its economic momentum has faded as GDP growth in Germany — the region’s largest economy — has contracted for two straight quarters. Downside risks for the region remain, and we are monitoring price pressures, which have moderated at a slower pace than in the U.S.

Central banks look to end their rate hikes

The renewed rally in bond yields in August and September pressured stocks and bonds, with all major global equity indexes posting losses in Q3. While most central banks are not rushing to cut interest rates, they are signaling a pause in rates hikes and likely the end of their tightening cycles by year-end.

Notable progress in inflation, together with central banks applying less pressure on the brakes, could help improve performance in the quarters ahead.  

Valuations reflect low expectations

While global risks remain, we believe many are already reflected in international equity markets.

Developed-market stocks are trading at a 30% discount to U.S. stocks (versus their 12% historical discount), while emerging-market equities are at a 40% discount (versus their 25% historical discount). With the difference between U.S. and European policy rates likely to narrow, the U.S. dollar could weaken, also helping international returns.

Action for investors

We remain neutral on international developed and emerging-market stocks and recommend staying close to strategic, long-term allocations. Attractive valuations better reflect the weaker growth outlook, while international diversification may help reduce portfolio volatility.

What’s the outlook for government debt?

While U.S. federal debt has risen faster in recent years, higher interest rates pose the added challenge of sharply higher annual interest payments. If rates begin to ease, as we expect, this will relieve some pressure, but mounting government debt will remain a broader-term risk.

We don’t see the debt situation being a near-term threat to the economy, but we do believe it will require tough fiscal choices down the road.

Rising interest rates add to budget stress

While Federal Reserve interest rate hikes have been in the spotlight in terms of the implications for the economy and financial market performance, higher rates also raise the cost of government financing. Annual interest expense is poised to reach $1 trillion, a figure that has doubled since 2017.

While sizable, interest expense is still near 2% of GDP.* For perspective, this figure exceeded 3% in the early 1990s. But rising interest payments are adding to the budget deficit, while rating agencies are evaluating government downgrades and partisan budget battles have threatened a government shutdown.

Interest payment pressure should subside somewhat as interest rates pull back from this year’s highs. But we don’t expect the return of the cheap government financing we saw when interest rates trended near historic lows.

To us, this poses the potential for some federal spending constraint in 2024, relative to the significant jump in government outlays over the past year. This could present an additional headwind to GDP growth.

Federal debt is a future risk

Total federal government debt is $32 trillion and counting, a trend that, left unaddressed, will prove problematic down the road. We don’t believe a default is realistic, but the debt load could reach a level at which it begins to crowd out private spending and investment.

One solution would be to target an annual budget deficit that is below the growth rate of nominal GDP. The U.S. economy’s resiliency is an advantage, but we doubt this will eliminate the need for tough fiscal decisions that, in our view, will include potential adjustments to taxes and spending.

Entitlements such as Social Security, Medicaid and Medicare — which combine for nearly half of annual federal spending — may be up for discussion, though likely not for another decade or two.

Action for investors

Don’t let doomsday predictions of an impending debt crisis derail your strategy or your portfolio decisions. We think U.S. Treasury bonds remain a safe investment and should be part of a well-diversified fixed-income allocation.

Strategic asset allocation guidance

Our strategic asset allocation represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.

Diversification does not ensure a profit or protect against loss in a declining market.

Opportunistic asset allocation guidance

Our opportunistic asset allocation represents our timely investment advice based on current market conditions and our outlook over the next one to three years. We believe incorporating this guidance into a well-diversified portfolio may enhance your potential for greater returns without taking on unintentional risk.

Visit edwardjones.com for a discussion of portfolio performance.

Investment performance benchmarks

It’s natural to compare your portfolio’s performance to market performance benchmarks, but it’s important to put this information in the right context and understand the mix of investments you own. Talk with your financial advisor about any next steps for your portfolio to help you stay on track toward your long-term goals.

Asset class performance

U.S. equity sector performance

^{Source: Morningstar Direct, 6/30/2023. Cash represented by the Bloomberg US Treasury Bellwethers 3-Month index. U.S. investment-grade bonds represented by the Bloomberg US Aggregate index. U.S. high-yield bonds represented by the Bloomberg US HY 2% Issuer cap index. International bonds represented by the Bloomberg Global Aggregate Ex USD hedged index. International high-yield bonds represented by the Bloomberg Emerging Market USD Aggregate Index. U.S. large-cap stocks represented by the S&P 500 Index. Developed international large-cap stocks represented by the MSCI EAFE index. U.S. mid-cap stocks represented by the Russell Mid-cap index. U.S. small-cap stocks represented by the Russell 2000 Index. International small- and mid-cap stocks represented by the MSCI EAFE SMID index. Emerging markets represented by the MSCI EM index. All performance data reported as total return. An index is unmanaged and is not available for direct investment. Performance does not include payment of any expenses, fees, or sales charges, which would lower the performance results. The value of investments fluctuates, and investors can lose some or all of their principal. Past performance does not guarantee future results.}