Quarterly Review and Outlook - October 2023

Dear Clients and Friends,

Time and tide wait for no man.

Chaucer’s “The Clerk’s Tale,” part of the broader Canterbury Tales collection and the source of our proverbial opening quote, can be interpreted as a tale of enduring patience, but also one of submission and passivity in the face of adversity. In the tale, we learn of young queen Griselda’s tolerance for her husband’s cruel tests of loyalty and faithfulness, and how, in time, she is rewarded for her perseverance. (Spoiler: they live happily ever after.) Now, when it comes to adverse financial market conditions, we at Evermay often tend toward a passive approach as well, knowing that most of the time, patience and a steady hand at the helm have been the keys to successfully navigating choppy fiscal waters. Once in a while, though, the economic tides change and financial currents become erratic, requiring a more hands-on course of action.

Notably, since our letter to you in early July, interest rates have moved meaningfully higher even as inflation expectations moderated and projections of US economic activity point to a probable deceleration in 2024. In fact, across all bond maturities, the US Treasury yield curve is now near or above the highest levels of the past 20 years, according to FactSet.[1] One might expect persistently high interest rates if the economy and inflation were poised to zoom higher. Wall Street consensus forecasts hint at a different story: Gross Domestic Product (GDP) is expected to decline from the current 2.0% annualized rate to a dawdling 0.7% pace next year, highlighting the possibility of at least a mild recession in the not-too-distant future. Similarly, the Consumer Price Index (CPI) is projected to show inflation dropping from the current year’s 4.1% rate to a more Fed-friendly 2.6% level in 2024.[2] If these forecasts prove accurate, or are even simply in the ballpark, the odds grow that the Federal Reserve might well consider a more dovish interest rate policy as soon as next year. And if that proves to be the case, then now might be the time to make modest changes to our clients’ bond positioning.

Time and tide wait for no man.  A pompous and self-satisfied proverb, and was true for a billion years: but in our day of electric wires and water-ballast we turn it around: Man waits not for time nor tide.

As we have noted in prior letters and conversations, we have been “short duration” in our fixed income exposure for the past few years, which in simple terms means we have held bonds and bond funds with very short average maturities relative to the widely used benchmarks.[3] We believe this strategy has worked favorably for Evermay clients, who have been able to take advantage of the steady rise in interest rates that began at the end of 2021 by reinvesting the proceeds of maturing short-term bonds at increasingly higher levels. Moreover, our view remains that our clients’ fixed income holdings should be viewed as ballast for the portfolio, and we do not want to take excessive credit or interest rate risk in that asset class. Shorter duration bonds, by their nature (and confirmed by mathematics), are less volatile than longer-duration bonds, and, thanks to the atypical, inverted shape of the Treasury yield curve over the past year and a half, our clients have actually earned higher yields owning those short-term, less risky securities than if they had held longer-term bonds.

The goal is not to sail the boat, but rather to help the boat sail herself.

Navigating change is rarely easy, and forecasts of significant moves in the financial markets often miss the boat. That said, we believe our clients’ patience in holding short-term fixed income securities has thus far been rewarded, but now may be the time to adjust the sails, just slightly, as we head into murkier economic waters.  By our estimations, an average bond duration slightly longer than the short-term fixed income benchmark should allow clients to lock in currently high interest rates for a longer period of time, even as we maintain a laddered approach to our individual bond holdings (where appropriate) and preserve portfolio liquidity via the use of short-term bond funds. We may be somewhat early in implementing this change, but a small dose of opportunism while interest rates are near two-decade peaks seems prudent to us.

***

In the last quarter, the stock market saw heightened volatility as the rise in interest rates gave a haircut to equity valuations. The S&P 500 lost 3.27% on a total return basis during the three-month period, but was still up more than 13% on the year through the end of last quarter.[4] Earnings expectations for S&P 500 companies rose slightly during the period, as many second quarter earnings reports (released during the third quarter) came in above forecasts. Though the financial press still pushes forth the idea that only a small handful of companies are driving index performance, we find it notable that, of the 500 companies in the large cap stock benchmark, 380, or 76%, reported earnings above expectations. And, at present, operating earnings for the S&P 500 are projected to grow another 12% in 2024, according to data from Standard and Poor’s.[5]   

We thus remain cautiously optimistic for the remainder of the year, though the uncertainty caused by higher interest rates could drive continued volatility for both stocks and bonds. As always, we remain vigilant to possible changes to economic and market prospects. We recognize there are uncertainties to any outlook and surprises may yet happen, in the markets and in our personal and professional lives. We encourage you to reach out at any time to discuss your portfolio to ensure your mix of assets is appropriate and aligned with your financial goals.

With best wishes for the last quarter of 2023,

Mitch Schlesinger

Chief Investment Strategist