Inﬂation has started to cool off, and real economic growth continues to be stronger than most forecasters were predicting to start the year. As economic growth has remained strong, those predicting a recession this year were likely incorrect. However, there are clouds on the horizon, and the biggest longer-term threat to economic growth is the U.S. government’s mounting debt relative to GDP (Gross Domestic Product).
Consumer spending could come under pressure as pandemic-level savings are depleted and student loan payments restart. Since the Federal Reserve started tightening, auto loan and credit card delinquencies have increased, suggesting that some consumers may be overextended. Global inﬂation remains elevated, and with a trend toward deglobalization, slowdowns internationally have been more pronounced, especially in China. Oil prices have increased sharply over the past three months as OPEC+ countries have cut production.
Sources of Stability
Core inﬂation is trending down, and although it remains above the Fed’s 2% target, the U.S. economy will likely avoid a recession in 2023. The labor market is still strong with historically low unemployment. The Fed is likely near the end of its tightening cycle, and although markets still see the possibility of one additional rate hike, the economy continues to deliver strong results. The services sector continues to be expansionary. Fiscal policy remains accommodative despite the strong economy and restrictive rates.
Economic Spotlight: U.S. Debt Downgrade
On Aug. 1, 2023, Fitch downgraded the U.S.’s long-term foreign-currency issuer default rating to 'AA+' from 'AAA', its highest possible rating. The credit rating agency cited deteriorating ﬁscal conditions, weaker governance, as well as an underfunding of Social Security, Medicare, and Medicaid (along with an aging population) as justiﬁcation. This was the second time in history that a rating agency has lowered the U.S. debt rating, following Standard & Poor's downgrade to 'AA+' from 'AAA' in 2011.
Practically speaking, the downgrade does not have much of a near-term impact. This is a signal, however, that the U.S. is not invulnerable to deteriorating credit conditions and downgrades. Over the longer term, if foreign investors lose conﬁdence in the U.S. government’s ability, or willingness, to repay its debts, they may choose to sell a portion of their Treasury debt, putting upward pressure on interest rates. And with 31% of federal debt maturing over the next 12 months, higher rates could continue to exacerbate the U.S. government's deﬁcit problem.
Stocks pulled back a bit in the third quarter though they are still solidly in positive territory for the year. Year-to-date through September 30, the Russell 3000 was up 12.4% while the MSCI World ex-US was up 6% and the MSCI Emerging Markets was up 3.4%. All three indices delivered slightly negative returns in the third quarter. So far in 2023, large-caps have outperformed small-caps and growth stocks have outperformed value stocks.
In the bond market, yields remain elevated, presenting a nice opportunity for high-quality income for investors.
For those of us invested in the value premium, we saw relative outperformance vs growth stocks in Q3. Globally 4.9% premium. Currently, U.S. and international value stock valuations, measured by P/E Ratio, are sitting below their recent historical averages, while U.S. Large Growth is above recent historical averages. All else being equal, we would like to purchase stocks with a lower P/E ratio and pay less for a dollar of earnings, because low valuations today imply higher future returns and vice versa.
It is notoriously challenging to find an indicator that consistently predicts negative value premiums. Regardless of value’s recent performance, investors should expect value stocks to perform better than growth every day because a lower relative price is associated with a higher expected return. That is a strong incentive for investors to maintain a disciplined stance on their asset allocation, so they can capture the outperformance when value stocks deliver.
1. Federal Reserve Bank of Atlanta. GDPNow™. Retrieved Sept. 28, 2023.
2. Bureau of Labor Statistics. Consumer Price Index Summary, August 2023. Retrieved Sept. 28, 2023.
3. CME Group. CME FedWatch Tool. Retrieved Oct. 5, 2023.
4. Fitch Ratings. Fitch Downgrades the United States’ Long-Term Ratings to ‘AA+’ from ‘AAA’; Outlook Stable. Aug. 1, 2023.
5. Reuters. US government shutdown bad for country’s credit, warns Moody’s. Sept. 25, 2023.
6. Returns for Russell 3000, MSCI World ex-US, MSCI Emerging Markets, CCLFX, QSPRX, and SHRIX are from Morningstar. Yield data, rate hike probability, and returns for LENDX and SRRIX from Bloomberg.
7. Image Source: Morningstar Direct 2023. Major Asset Class Results (index representation) as follows: U.S. Stocks (Russell 3000 Index), International Stocks (MSCI World ex USA Index IMI [net div.]), Emerging Markets Stocks (MSCI Emerging Markets IMI Index [net div.]), and US Bonds (Bloomberg Barclays US Aggregate Bond Index), Global Bonds (ex US) (Bloomberg Barclays Global Aggregate ex-USD Bond Index [hedged to USD], and USD (Bloomberg DXY US Dollar Index). All indexes detailed at end of presentation. Past performance is not a guarantee of future results. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Information from sources deemed to be reliable, but its accuracy cannot be guaranteed.
8. Morningstar. P/E ratios are based on the trailing twelve month average and are observed quarterly using the following mutual funds and exchange traded funds as proxies: US Market Equity (iShares Core S&P Total US Stock Market ETF, ITOT), U.S. Small Value Equity (iShares Russell 2000 Value ETF, IWN), International Market Equity (VEA December 2006 – December 2016; IDEV January 2017 – Present), International Small Value Equity (DISVX December 2006 – June 2019; AVDV July 2019 - Present): Data through September 30, 2023.