Market Commentary - 2023 - Q3

Key Takeaways:

  • Stocks enter correction territory as geopolitical risks escalate, rates continue to increase
  • A small group of stocks has driven market swings this year
  • GDP growth rebounded strongly in Q3 2023, despite many economists' pessimism
  • The impact of regional wars on markets depends on the economy
  • Over long periods of time, markets have recovered from geopolitical conflicts
  • Bond market volatility has been elevated
  • The job market is showing signs of softening
  • Outlook

Stocks enter correction territory as geopolitical risks escalate, rates continue to increase

The market recently fell into correction territory, typically defined as a 10% decline from the previous peak, a fact that may seem to be at odds with many measures of strength in the underlying economy. Since the end of July, the S&P 500 has pulled back 10.3% due to concerns around rising interest rates, Fed policy, slow growth in China, political uncertainty in Washington, and more. Even at its recent peak, the market had not fully recovered from last year's bear market, coming within 4.3% of its all-time high at the start of 2022. Year-to-date, the S&P 500 has still gained 7.2% and the Nasdaq 20.8%. (As of 10/30/23).

A small group of stocks has driven market swings this year

Given these macroeconomic concerns, the biggest contributors to both the up and downs in major indices have been technology stocks. One group of these high-flying stocks is now referred to as the "Magnificent 7" and includes Apple, Microsoft, Alphabet, Amazon, Meta, Nvidia and Tesla. As the chart above shows, this group has gained 77% on average in 2023, contributing significantly to the returns of both the Nasdaq and S&P 500. Over the past five years, they have risen 211% compared to 41% for the Nasdaq and 27% for the S&P 500.

GDP growth rebounded strongly in Q3 2023, despite many economists' pessimism

What may drive cognitive dissonance for some investors is that these market moves are happening at a time when the economy is far stronger than previously believed. The latest GDP report for the third quarter was significantly better than economists had expected just a few months earlier. Not only did the economy grow 4.9% at a quarter-over-quarter annualized rate, after accounting for inflation, but growth was also broad across consumer purchases of goods and services, business investment, and government spending.

In fact, this was the best quarterly GDP number since 2021 when the economy surged after the pandemic. Growth rates this strong have only occurred a few times over the past two decades - prior to 2021, it last occurred in 2014, and before that in 2006. That said, some investors are naturally concerned that this may not continue and that a recession is still possible if rates remain elevated and if the Fed does tighten further. There are also worries that consumer spending may decelerate as households draw down their excess savings and private investment could slow as a buildup of business inventory reverses.

Still, it's undeniable that the economy has been far stronger than economists expected. While it is still early, consensus expectations are for the economy to grow 0.8% in the fourth quarter while the Atlanta Fed's GDPNow model is forecasting 2.3%. Either way, this year has shaped up far better than many had feared, especially because inflation continues to improve toward the Fed's long-run target and the labor market remains strong. If you had told an investor a year ago that conditions would be this positive, they most likely would have guessed that we would be in the midst of a new bull market.

The impact of regional wars on markets depends on the economy

Without minimizing or trivializing the severity of this conflict, especially the humanitarian consequences, many investors will naturally have questions and concerns about the impact on markets in the coming weeks. What does history tell us about regional wars and their implications for markets and the economy?

Unfortunately, for long-term investors, geopolitical risk is unavoidable. Headlines on regional and global conflicts are alarming since they involve violence and the loss of life, and are therefore unlike the typical flow of business and market news involving earnings, valuations, and mergers and acquisitions. These events are also difficult to analyze and their outcomes challenging to predict. As a recent example, many of the predictions around Europe's access to oil and gas following Russia's invasion of Ukraine, fortunately, did not play out. So, while short-term traders may be tempted to guess the direction of oil prices, the S&P 500, and interest rates, it's often better for long-term investors to hold a properly diversified portfolio and stay level-headed as events unfold.

Calling the history of the Middle East complex would be a vast understatement, making the current situation even more difficult for investors to analyze. Many diplomats have spent their entire careers attempting to broker peace, countless volumes have been written on the subject, and decades, if not centuries, of ethnic and religious history complicate relations between the region's nation-states. At the risk of oversimplifying matters, the numerous attempts at achieving peace by the U.S. since the mid-twentieth century have been largely unsuccessful. While the Camp David Accords in the late 1970s and the Oslo Accords in the 1990s did improve relations and helped to end conflicts at the time, violence has erupted many times over the past decade.

Over long periods of time, markets have recovered from geopolitical conflicts

From the perspective of investors, it's always important to separate feelings and beliefs around politics and global matters from portfolio decisions. As the first chart above shows, the impact that wars have on markets varies depending on the business cycle. Some events such as 9/11 and the ensuing wars in Iraq and Afghanistan were met with market declines. This was because these events coincided with the dot-com crash which, while unrelated, required years to stabilize.

In contrast, most of the conflicts since the 2010s, including wars in the Middle East, the annexation of Crimea by Russia, and the on-going nuclear threats in North Korea and Iran, were against the backdrop of an expansionary economic cycle. While some of these periods experienced market declines over the following three to six months, economic growth tended to lift markets higher over longer time horizons despite geopolitical uncertainty. The history of strong bull markets in the 20th century across World War II, the Vietnam War, and the Cold War further underscores this point.

Of course, last year's invasion of Ukraine by Russia is still ongoing and, so far, markets have not yet recovered their previous peaks. Again, this is largely due to the interaction with other economic forces, namely rising inflation, supply chain disruptions, and elevated market valuations following the pandemic.

One direct impact of the Ukraine war and uncertainty in the Middle East is on energy prices. Oil prices did jump following the recent attack on Israel, with Brent crude rising from $84 per barrel to above $87, partially reversing the decline over the past two weeks from a high of about $97. However, this pales in comparison to the sharp rise in oil last year when prices approached $128. There was little direct impact on oil when Russia annexed Crimea in 2014, and even the 2019 drone strikes against Saudi Aramco by Iran and others, which knocked out 5% of global oil production overnight, saw only a short-lived reaction in oil markets. Thus, the impact on energy prices from Middle East conflicts is far from a sure thing.

Bond market volatility has been elevated

The recent market correction only pulled the S&P 500 back to levels last reached in May before then spurring the strongest rally of the year during which the market gained 5.9%. This is because investors feared the worst when rates jumped in October before new data showed that the backdrop is more balanced than expected - one in which inflation is slowing and economic growth is steady but decelerating enough to appease Fed policymakers. Markets often need time to adjust to these dynamics which naturally causes asset prices to swing.

While investors often focus on stock market volatility, using measures such as the VIX index, the volatility of interest rates and the bond market has been far more severe since the beginning of 2022. The 10-year Treasury yield, for instance, has made multiple roundtrips within a range of 4.5% to 5% since September. The accompanying chart shows the MOVE index of bond market volatility which has been elevated for over a year and a half. Fortunately, recent economic data have led interest rates to fall once again, calming markets.

The job market is showing signs of softening

One reason for this is the recent jobs report for October which showed that hiring slowed. The economy added 150,000 new jobs over the month which is less than the 180,000 that economists had expected. This was also a sharp decline from September's 297,000 new jobs, due in no small part to a drop in manufacturing employment due to factory strikes. Unemployment increased slightly from 3.8% to 3.9% while the labor force participation rate, which measures the percentage of the working age population either working or actively looking for work, declined slightly to 62.7%.

While these figures represent a slowdown in the job market in October, it's important to understand how they fit into the bigger picture. First, investors should never make decisions based on only a single month's numbers, whether it's the jobs report, the Consumer Price Index, or GDP. Not only are these figures subject to change but they are also only estimates with wide margins of error.

Second, and more importantly, investors have been anticipating a slowdown in the labor market in response to tighter monetary policy by the Fed. The softening of an otherwise strong labor market coupled with improvements in inflation represent the Goldilocks situation investors have been hoping for. A "soft landing" means that the Fed can pause its rate hikes and, as price pressures decline, possibly consider cutting rates over the next couple of years. Unlike in 2022 when the Fed had to raise rates rapidly, the possible end of the tightening cycle will likely create more stability and certainty for investors. In the ideal scenario, the gap between reality and expectations could shrink as the macroeconomic shocks of the past few years continue to fade.


Holding rates steady is precisely what the Fed did again at its November meeting. The Fed recognized that there have been important improvements to the inflation story while the overall economy has been healthier than expected. A softer labor market reduces the risk that inflation could surge unexpectedly, and unemployment is approaching the Fed's 4% forecast for the end of the year. The Fed's ideal situation is that interest rates remain high across the yield curve to keep the economy in check without the need for additional rate hikes.

Volatility and uncertainty will likely remain elevated for the coming months while the market keeps a close eye on interest rates and the labor market. When corrections do occur, markets often fall as much as 14% or more. Despite this, major indices have historically recovered in a few months.

What's more important is that rebounds often occur suddenly and unexpectedly, just as they did in mid-2020, earlier this year after the banking crisis, and throughout countless other examples. Trying to time this reversal perfectly often backfires since it means missing out on the earliest part of a recovery. Of course, the past is no guarantee of the future, but this a reminder for investors to stay focused on the long run and not get caught up in short-term market movements.

Investors should maintain a long-term perspective rooted in economic and market trends. Doing so is still the best way to increase the odds of achieving financial goals.

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