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10.17.23  |  Investment Management

2023 Outlook Theme #1: Markets Come to Terms with the “Hold” in “Raise and Hold”

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The most significant driver to Q3’23 markets was the continued rise in interest rates. Investors continue to wrestle with the Fed’s “raise and hold” mantra, of not only raising rates to around 5%, but then holding them there for the rest of 2023 and into 2024.  This was evident in the 10yr Treasury rising 76 bps to 4.57%, much more than the 2yr’s 17 bps rise to 5.04%. While there has been much talk of the inverted yield curve (the 2yr yielding more than the 10yr), this past quarter saw the 2-10yr inversion fall by 59 bps, even as interest rates were rising overall. Typically, an inverted yield curve resolves itself when interest rates fall across the board, and the short end falls more, as was the case in 2000, 2006, and 2018. In those three instances, once the 2yr and 10yr were equal, both subsequently declined, with the 2yr dropping more. In 2023, not only are rates still rising, but the gap is now narrowing because the 10yr is rising faster than the 2yr.

Chart 1

Driving this interest rate move is the markets finally believing the Fed’s plans to “raise and hold” to slow the pace of inflation. Since the Fed’s first rate hike on 3/16/22, it has pursued its fastest ever rate increase campaign (reflected in the surge in the 1yr Treasury from 0% to 5.39%) to combat the surge in inflation (Core CPI). Inflation has eased from its recent peak and, thanks to the rate hikes, the markets believe inflation will continue to fall, as reflected in the TIPS implied inflation rate of just 2.20%. The question is how much the economy will be impacted by this rapid shift. Ironically, it has been the recent strength in the economic data that has kept the Fed toeing its “raise and hold” line. Interest rates have had to adjust.

Chart 2

The continued strength of the economy in Q3’23 has kept the Fed’s (and market) hopes for a soft landing alive. Yet this optimism has caused interest rates to rise, as Markets Come to Terms with the “Hold” in “Raise and Hold”. This threatens both valuation (higher interest rates put downward pressure on PE ratios) and fundamentals (higher rates slow economic growth). This paradoxical back and forth that has caused the interest rate ups and downs and will likely persist. Going forward, the impact of interest rates on valuation, for both Equity and Fixed Income, remains a key question.

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2023 Outlook Theme #2: Rising Rates Create a Headwind for Equity Valuation

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