October was a difficult month for financial markets. U.S. stocks were down and U.S. Treasury yields were up (pushing their prices down). Geopolitical tension, heightened by the emerging conflict in the Middle East, was a factor but surging Treasury yields dominated sentiment for U.S. markets.

Benchmark 10-year Treasury yields marched past previous 2023 highs, and briefly pierced the psychologically significant 5.0% level, before closing the month at 4.90%, 0.33% higher than September’s end.

The capital loss from rising yields hurts both Treasury bond holdings and other fixed income markets, such as U.S. corporate bonds. Higher rates also take its toll on mortgage rates, with 30-year fixed-rate loans vaulting to around 8%, a level not seen in more than 20 years. More generally, the rising Treasury yields amidst relatively stable inflation rates have only further solidified high real yields (the yield paid less inflation), tightening financial conditions across the economy. As markets accept the U.S. Federal Reserve’s (Fed) prognosis that rates will stay higher for longer, the greater cost of capital is a dampener on the outlook for corporate profitability in the long term.

The good news was that the U.S. economy continued to hum along. Third quarter Gross Domestic Product (GDP) surged to 4.9% (more than doubling the second quarter’s 2.1%) and was the highest quarterly rate seen since the fourth quarter of 2021. Unsurprising, corporate earnings generally beat expectations for the quarter. That said, revenue growth was uninspiring, and forward guidance was muted. With the third quarter GDP surge fueled by consumption, the concern seemed to be that higher interest rates would eventually take their toll on the recently more audacious consumer. That concern may be warranted, as select data points to a struggling consumer. For example, more car owners have become delinquent on their payments. In September, 6.1% of subprime borrowers were at least 60 days past due on a car payment, according to Fitch Ratings, the highest delinquency rate in nearly 30 years. 

Softer unemployment isn’t helping. While the September jobs data was strong, adding 297,000 new jobs, growth decelerated to 150,000 jobs added in October and the unemployment rate ticked up to 3.9% from 3.8% last month. However, average hourly earnings slowed their gains slightly, rising just 0.2% over the month.

Nevertheless, inflation remains high. The core Consumer Price Index (CPI), which excludes the more volatile food & energy components, increased 0.3% month over month in September, the same as it did in August, and rose 4.1% versus September last year. With the core Personal Consumption Index (PCI), the Fed’s preferred measure, up 3.7% year over year in September (the same increase as in August and July), inflation remains too far above the Fed’s target of a long-term average near 2.0%.

However, the Fed again chose to remain on pause for the second consecutive month. In a unanimous vote, the rate-setting policy committee chose to leave rates unchanged, albeit at a 22-year high. As markets do not currently expect a hike in December, it seems likely interest rates will end 2023 at current levels.

Outlook: The long period of rising U.S. policy rates is likely near its end. But the toll that higher rates extract from economic growth has a lagged effect, and we believe the impact will become steadily more apparent as we head into 2024.

Third quarter growth and earnings results were encouraging, but we continue to believe U.S. corporate profit margins will be challenged in 2024 with slowing growth. Higher inflation helped companies raise real prices over the past year, but that tailwind of inflation enabling higher prices is dissipating as inflation has fallen and may likely continue to drift lower. Add tighter financial conditions, higher borrowing costs, and a slowing economy on top of a loss in pricing power, and we think it will be difficult for profits to continue to beat rosy expectations into 2024.

Should the economy slow more abruptly than the market currently expects, the Fed could relent and begin to talk about lowering interest rates. However, we believe they will be very reluctant to do so without a clear and significant decline in inflation or a great deal of confidence it will fall in the near term. We believe the Fed, which has the difficult task of balancing the so-called “dual mandate” of simultaneously targeting lower inflation and higher employment, currently favors the former and will do so until they are confident inflation has stabilized at appropriate levels.

In this environment, we continue to think bonds broadly can be compelling long-term investments. Short-term securities issued by either the U.S. Treasury or high-quality companies offer attractive yields given our expectation that the Fed is likely to keep short-term interest rates high into next year. While longer-dated Treasury bonds have been volatile recently, they offer the opportunity to lock in today’s historically high yields for the length of the bond. If we are right that Treasury yields are likely near their peak, then the total return realized in longer-dated bonds could be impressive as the capital appreciation gained from any decline in rates is added to the already attractive yield earned just by holding them.

High-quality corporate bonds also offer attractive yields, in our view, insofar as the underlying Treasury yield has risen significantly and the spread offered over that yield remains attractive. While this is most apparent in the high-yield (below investment grade) market, we are not convinced their current yields adequately compensate for the risks that could emerge from a slowing economy and increasingly tight financial conditions. Investment-grade corporate bonds, however, are more likely to weather any economic storms.

While weakness in stocks and bonds could well continue in the months ahead, our base case remains that significant further weakness in stocks or bonds is more likely to be short lived rather than longer term. While the short-term effects of volatility can be painful, these same periods can also offer opportunities for actively managed portfolios and investors who have heeded our words of caution and retained some flexibility to add risk when valuations become attractive.