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The Cornerstone Investment Commentary: 3rd Quarter 2023

Imagine a patient wanting to live normally, but the doctor keeps prescribing medication and a less active lifestyle to cure her illness.  And the patient is getting impatient!  This describes today’s financial situation:  The patient is the financial markets, the doctor is the Federal Reserve, the medication is interest rate hikes and the illness is inflation.

All of this led to a pause in your portfolio’s recovery starting in August, resulting in this quarter’s declines of 2-4%.  What’s going on now fits the pattern of the last two years.  When daily economic news suggests that the Federal Reserve will not need to keep interest rates quite so high for quite so long, markets react positively.  This is what we mostly saw starting last Fall and continuing through July.  The opposite is also true:  Daily economic news suggesting the Fed will need to keep rates higher for longer brings negative results, as we’ve seen since August.

Financial markets never move up in a straight line, so patience is often needed to avoid making mistakes.  The good news is that, looking into 2024, trends are moving in directions of allowing the Fed to eventually ‘back off’, which we expect to be favorable for the positive results that existed through mid-summer.  More specifically:

  • Inflation continues to cool.  When the Social Security cost-of-living adjustment (COLA) is announced later in October at ~3.5%, it will be a big drop from the 8.7% of a year ago.
  • Most data shows the labor market cooling (but without significant layoffs) – a nearly ideal scenario.
  • The biggest question seems to be whether or not the Fed will raise rates one more time – a far cry from the interest rate uncertainty of six months ago.
  • Each of these items makes the case for the ‘patient’ (the financial markets) to be feeling better before long and for the financial recovery to continue.
  • As this occurs and upward pressure on interest rates subsides, it would not be surprising to see the U.S. dollar decline in value and give a boost to foreign stocks.  This also occurred in late 2022 and early 2023.

The current situation also has implications for the bond market.  In the last 12 months, short-term bonds – the bulk of our client holdings – have gained ~2.5%.  These bond holdings now yield over 5% and could easily return more going forward once upward interest rate pressures ease, especially in the case of your intermediate-term bond holdings.  That is even more likely if signs of a recession begin to appear.  Because of this, we believe your portfolio is positioned well to weather any economic slowdown, should one occur.

These are definitely interesting times, which some may even call ‘unsettling’.  For example, good news (‘the labor market is still healthy …’) is indeed good, unless it is too good (‘… but it could cause more wage inflation if it’s too healthy’)!  And then it’s seen as ‘bad’ news in the moment … at least until the next bit of news arrives.

Our belief that inflation and interest rate increases would subside in 2023 led to our strategy of keeping equity allocations higher this year.  This has proven beneficial to your investment results, and we patiently look for this to resume.  As it does, we will take opportunities to rebalance back toward ‘normal’ equity levels going forward.

As always, we will meet these unfolding conditions with the thoughtful and prudent approach you have come to expect from us.  With our thanks for the continuing opportunity to work with you, we send our best wishes to you and your family for a healthy and happy upcoming holiday season.