The US economy continued to exhibit remarkable resilience during the third quarter of 2023 in the face of mounting headwinds. Forecasts for real economic growth were revised upward over the past few months, as improving inflation numbers and continued strong employment encouraged consumers to spend freely, even while taking on more debt. The economy remained strong despite the most rapid Fed tightening cycle in history, a very inverted yield curve, a slowdown in bank lending, and increasing credit card debt coupled with declining household savings.

While current economic activity continues to hold up, concerns are mounting that these issues, along with potential additional ones, will ultimately drive down economic growth and result in a recession. New concerns include higher energy prices, the auto strike, resumption of student loan payments, and a possible government shutdown. Reflecting these issues and concerns, we continue to forecast an economic slowdown, and believe that the Fed is unlikely to change its rate policy during the coming year.

Any asset allocation diversification resulted in underperformance in the third quarter of 2023, as the narrow group of US growth stocks (the “Magnificent Seven”) continued to dominate returns throughout much of the period. After a strong start for many segments of the market in the month of July, investors appeared to take the Fed’s message of interest rates being “higher for longer” more seriously. This led to rising bond yields, which in turn put downward pressure on both stocks and bonds across sub-asset classes. Commodity prices and real assets bucked the trend and produced gains that partially offset equity and bond losses. The S&P 500 Index declined by -3.3% for the three-month period, while bonds (as measured by the Bloomberg Intermediate Government/Credit Index) declined by 0.8%.

Diversification into increasingly better-valued equity asset classes, including mid- and small companies, led to underperformance compared to the large-company S&P 500 index in the third quarter. The S&P400 Mid-Cap and S&P600 Small-Cap indices declined by 4.2% and 4.9%, respectively, for the three-month period. Our positioning entering the third quarter was tilted toward mid- and smaller companies, but as it became increasingly clear that the economy will slow, we shifted some of this exposure to larger, value-oriented companies, which are also inexpensively valued. We expect the market will broaden away from the highly valued growth stocks, and in so doing, will recognize the inherent value in both smaller companies and large-cap value stocks.

International stocks, as measured by the MSCI World ex US index, also lagged US stocks during the quarter. International stocks are trading near historic valuation lows relative to US companies and had solidly outperformed toward the end of 2022. They performed better than mid- and smaller US companies during the third quarter, but lagged the S&P 500 Index, declining by 4.0%. This occurred in part because of a stronger dollar. We maintain our position in developed international stocks and continue to have no exposure to emerging market stocks.

We remain underweight bonds relative to strategic targets. Short-term government and corporate bonds produced small positive gains for the third quarter and our allocation to these maturities was a positive contributor to investment performance. With rising yields, however, intermediate bonds produced negative returns for the period. Corporate spreads did not widen as rates rose, and high-yield bonds produced smaller losses than intermediate Treasurys or Corporates. We remain overweight toward corporate bonds over Treasurys and expect to continue with this position as long as the economic environment remains solid.

The Bloomberg Commodity Index produced positive results for the period, returning 4.8%. Private real assets declined slightly for the quarter, but still outperformed the bond market, thereby fulfilling their expected role of low correlation to stocks and bonds. Private real estate continued to struggle in the third quarter, although several sectors within real estate look attractive. We continue to allocate to these alternative areas, which should perform well relative to bonds in a rising rate environment.

As we look toward the end of the year and into 2024, we expect slowing in the economy as the headwinds described earlier weigh down on growth. We expect earnings to pick up into 2024, which should benefit early cycle stocks and asset classes such as mid- and small companies. Valuations of international companies remain compelling, as do valuations of small- and mid-sized companies. Higher interest rates may have a negative impact on highly valued growth stocks, and we remain well diversified to benefit from the expected broadening of the market away from the narrow growth winners to date. Bonds appear attractive based on yields above 5% and provide solid cash flow. They should also provide stability once the Fed finishes raising interest rates.

In the third quarter of 2023, US Treasury yields were influenced by a variety of factors. Two of these—restrictive monetary policy and lingering inflation—have become well known to investors. Others, such as a ballooning federal deficit, a looming government shutdown, and Fitch’s downgrade of the United States credit rating, have come into focus. All five of these factors are related. Inflation, for example, has forced the Fed to aggressively tighten financial conditions, and has also led to a sharp increase in the federal deficit as Social Security, Medicare, and Medicaid costs were indexed upwards. As it pertains to the government shutdown, high government spending is one of the main points of contention. Within the US Treasury market, increased deficits mean larger borrowing needs and more Treasury bonds that need to be sold to investors. Recent projections for the third quarter show that the US Treasury’s borrowing needs are 52% higher than the second quarter (chart below). Unfortunately, increased issuance comes as demand for Treasurys continues to weaken, especially from domestic banks and foreign central banks. The convergence of these factors sent yields sharply higher in the third quarter.

The increase in Treasury yields can be largely attributed to the Fed’s forward guidance, which many have referred to as a “higher for longer” outlook. Specifically, recent increases in yields are less related to projected Fed Funds Rate hikes than to the length of the time that the Fed intends to keep rates elevated. During the quarter, market acceptance of the Fed’s intentions was reflected in yield changes for specific Treasury maturities. As shown in the chart below, the 2-Year Treasury increased by merely 0.15% to 5.04%, reflecting the market’s view that the Fed Funds Rate is close to a peak. On the other hand, there were substantial increases in the 10-Year and 30-Year yields, which both increased by 0.84% in the quarter, to 4.68% and 4.70%, respectively. Those yields are the highest they have been in over ten years, and it is clear that the bond bears have the upper hand at the moment. A slowing economy or a recession could cause a decrease in yields, but despite some early signs of weakness, the resilience of the US economy has been one of the major themes year-to-date.

Credit spreads have consistently reflected a resilient economy and continued to be stable in the quarter.  The Bloomberg US Corporate High Yield Index measures the additional yield compensation (credit spread) provided over a comparable maturity US Treasury and is a measure of credit stress. This index started the third quarter at 3.90% (390 basis points), tightened to 3.66%, then widened to 4.02%.  Notably, this measure of stress is still well below its ten-year average of 4.26%. Fundamentals within the Investment Grade and High Yield credit markets are deteriorating slowly but are still solid. Net financial leverage and free cash flow compared with debt are close to average, while the ability for issuers to cover their interest costs is still well above average. We are looking to opportunistically allocate to the High Yield asset class on any material weakness.

Municipal bond yields have been as volatile as their US Treasury counterparts. During the quarter, municipal bond yields increased by 0.85%. The municipal bond market is a less liquid one, where daily price changes can be driven by retail investors, and therefore it can be prone to bouts of volatility. In the last trading week of September alone, municipal bond yields moved up by 0.5%. Volatility can create opportunities for selective buyers, especially with tax-free bond yields approaching 4%. At a 35% marginal tax rate, a 4% tax-exempt yield is the equivalent of a 6.15% taxable yield. Broadly, the credit fundamentals for US states are robust. First quarter data showed that an impressive 38 states have inflation-adjusted tax revenue that exceeded projections based on their pre-COVID growth rates.¹ In addition, state rainy day fund balances have reached a massive $164 billion, led by California, which had a $76 billion rainy day balance as of 2022.² Higher interest rates are also improving the funded status of state pension and other post-employment benefit (OPEB) obligations. States have full coffers, but there are headwinds on the horizon. The top two sources of most states’ revenue are personal income taxes and sales tax – and the growth rates of both have been slowing. Federal aid to states is also expected to be lower, especially compared to previous periods that contained generous COVID-related aid. Despite these headwinds, we find yields on municipal bonds to be appealing, especially when investing in strong, credit-worthy issuers.

The final quarter of 2023 will undoubtedly come with more surprises and certainly more interest rate volatility. We are mostly neutral to our duration benchmarks given the unknown path of interest rates.  We continue to hold a meaningful allocation to government securities, corporate bonds, and high-quality municipal bonds. With tax-adjusted yields above 5%, the total return outlook for fixed income is significantly brighter than its recent history.

¹ Theal, Justin & Fall, Alexandre. “State Revenue Declines From Record Highs” Pew Research Center, 27 September 2023, https://www.pewtrusts.org/en/research-and-analysis/articles/2023/09/27/state-tax-revenue-declines-from-record-highs

² Boddupalli, Aravind. “State Rainy Day Fund Balances Reached All-Time Highs Last Year” Tax Policy Center – Urban Institute & Brookings Institution, 6 September 2023, https://www.taxpolicycenter.org/taxvox/state-rainy-day-fund-balances-reached-all-time-highs-last-year

Last quarter we cautioned investors not to shrug off the losses of 2022 as equity markets rebounded.  Economic data remained mixed, and the market’s advance had been driven by a handful of mega-cap technology stocks as the promise of Artificial Intelligence (AI) captured the investing public’s imagination. This warning turned out to be prescient as the inflation pressures and rising interest rates that characterized 2022 returned to center stage toward the end of the quarter. The S&P 500 ended the quarter more than 6% below its peak reached in late July, and other areas of global equity markets fared even worse. The shift in investor sentiment over the past three months was almost palpable as near-euphoria gradually morphed into outright pessimism and reset market expectations to levels that seem much more reasonable as we consider potential risk and return going forward.

The economic momentum coming out of the pandemic remains impressive and both the labor market and credit markets remain consistent with ongoing economic growth. While the Leading Economic Index (LEI) has remained mired in negative territory for over a year and the yield curve has been inverted even longer, higher interest rates seem to have slowed—but not derailed—economic activity. Recession risk remains elevated but isn’t going to become our base case unless layoffs begin to pile up or credit markets show signs of disruption.

While we continue to expect the economy to muddle through, corporate earnings have been in decline and the most recent quarter’s earnings for the S&P500 were down 5.8% relative to this time last year. Despite this decline, earnings did come in ahead of expectations and the current level represents nascent stabilization as a few months ago earnings were down over 9% versus last year, as shown in the chart below. In addition to an impediment for the overall stock market to overcome, the decline in earnings also boosted the relative appeal of the same large growth stocks that led the market in the first half of the year. The shares of large growth companies rebounded from depressed valuations following the correction of 2022, and added to those gains as earnings growth became scarce.  Unfortunately, the valuations of these growth companies began to look more vulnerable as interest rates rose steadily towards the end of the quarter.

Interest rates underlie the valuation of most investments, so sudden changes in interest rates can disrupt multiple financial markets simultaneously as we saw in 2022. This is especially true when the increase in interest rates outpaces a shift in inflation expectations as occurred last year.  In the chart below, the yield of US Treasury Inflation Protected Securities (TIPS) over the past 25 years shows a gradual decline in real yields followed by the resurgence that is underway. These interest rates are “real” because they are an incremental rate paid over the inflation rate. While not nearly as disruptive as the leap from -1 to +1.5 last year, the sudden jump this quarter has significant implications for equity markets going forward.

Higher real interest rates decrease the value of the future cash flows that support the valuation of stocks, but especially for slow-growing and highly leveraged dividend payers like the utility and real estate sectors that have been the worst performing sectors so far this year. A jump in real rates should also have an outsized impact in high-growth areas like technology where most of the value is based on cash flows in the distant future. This was the case in 2022, but it has not yet been the case in this latest leg up in real yields. While evidence is limited so far, the recent surge in real rates could set the stage for a reemergence of value investing that places greater emphasis on cash flows in the here and now.  Ultimately, the current bout of volatility may provide the catalyst for the broadening out of equity market participation that we had begun to expect last quarter.

While it’s uncomfortable to invest in volatile times like these, we continue to view the long-term equity outlook as bright given current valuations and economic momentum. Short-term uncertainty is high, but we remain committed to a disciplined, diversified approach with a tilt toward high quality and reasonably priced equities that seems likely to generate attractive risk-adjusted returns over time despite a challenging 2023. This approach also bolsters our confidence in remaining fully invested in equities despite the mixed economic backdrop while carefully watching for signs of more serious economic disruption, such as cracks in the labor or credit markets.

A Tale of Two Markets

It was the best of times; it was the worst of times. This classic Dickens line captures the stark divide between clean-tech fixed asset investment in the private sector and sentiment in the clean-tech corner of the public equity market. At the center of this conflict is the Inflation Reduction Act (IRA) and an increase in financing costs via higher interest rates. Beneath the surface, there are questions around economic development, inflation and costs, strategic supply chain dependencies, politics, and of course, decarbonization. As always, it’s important to start with the facts on the ground.

The IRA was signed into law on August 16^th, 2022, creating a roadmap for decarbonization of the US economy. The program is centered on tax incentives designed to stimulate demand and to build domestic supply chains and manufacturing across solar, wind, hydrogen, batteries, electric vehicles, and related infrastructure. There are demand-side incentives in credits to renewable energy developers and consumers interested in EVs, heat pumps, and other equipment. There are also supply-side incentives in the form of unit-based manufacturing credits throughout the supply chains supporting the transition.

Over the twelve months since the IRA was signed into law, fixed asset investment across a number of industries has picked up in the US.  Bloomberg New Energy Finance (BNEF) counts a total of 84 major clean-tech factory announcements over the last year, representing about $84 billion in private sector investment. Broader estimates capturing clean energy generating projects and expansion of existing facilities to meet demand, point to numbers roughly three times the BNEF totals. Estimates of job creation range from 74,000 to 170,000, depending on the scope of analysis.

The blue line in the chart below shows the increase in manufacturing-related construction spending in the US, which began to pick up after the Bipartisan Infrastructure Investment and Jobs Act was passed in late 2021 and accelerated after the IRA was signed into law. There is no doubt that this activity is a stimulant to the US economy, at a time when unemployment is at historic lows and the Fed is fighting elevated inflation. While it is certainly possible that the IRA reduces inflation many years down the road, it is clearly doing the opposite currently.

Beyond any impact on economic growth and inflation, there is the question of program cost to the government and how this plays into the upcoming election cycle. The initial Joint Committee on Taxation (JCT) estimate of program cost for the clean energy-related portion of the IRA was $270 billion, though it was clear almost immediately that this would be well below reality. Today, the estimated cost of clean energy tax credits by the JCT stands at $662 billion. Estimates from Wall Street firms such as Goldman Sachs are above $1 trillion. There is no doubt that the cost of the IRA will be a hot topic right through the 2024 presidential election.

While there will be a heightened level of rhetoric on both sides of the IRA debate, many political analysts believe it is unlikely the entire law would get overturned on a GOP win in 2024. That said, a Republican sweep would increase the odds that major cost drivers in areas where there is a wider political divide, namely EV purchase subsidies, will be at some level of risk. For most of the rest of the legislation, it is important to keep in mind that roughly 70% of the clean-tech activity noted earlier—and therefore much of the job creation—is happening in states with Republican governors.

Beyond short-term tactics, with climate change a given and rapid action required to avert more dire outcomes, decarbonization and electrification is the baseline. This is a long-term transition and therefore strategy matters as much if not more than tactics. The US was clearly behind countries like China in developing supply chains to support the energy transition and electrification. This strategic disadvantage has become clear, driving the need to build domestic capacity. As noted above, this comes at a cost, particularly up front, as fixed asset investment accelerates. Over a longer period of time, supply and demand will not line up perfectly, driving cycles within a longer-term trajectory. We are getting a taste of this currently in the clean tech-related part of the stock market.

Since the signing of the IRA just over a year ago, valuation of the S&P Global Clean Energy (SPGCE) Index has moved steadily lower (orange line in the chart below).  Activity on the ground is driving earnings estimates higher, a trend we expect to continue as most (if not all) of the IRA incentives will likely run through the originally planned program timeline. Despite an improving earnings outlook, stock prices have been trending lower, as investor sentiment has become increasingly negative. A stronger economy and upward pressure on inflation is driving interest rates higher, a dynamic that in isolation negatively impacts project-level economics. Additionally, higher rates put pressure on valuation multiples for higher-growth companies where earnings and cash flows are farther out in the future. Investors are also clearly discounting some possibility that portions of the IRA might be at risk in a Republican-sweep scenario.

While uncertainty around interest rates, costs, the short-term balance of supply and demand, and political posturing will likely remain over the next few quarters, the medium to long-term outlook remains bright. With valuations now broadly undemanding and action on the ground supporting future growth, long-term investors should keep a close eye on the clean tech-related part of the market heading into 2024.

Alternatives Overview

The current state of alternative investments is challenging to summarize because benchmark returns show performance that doesn’t adequately capture the degree of dispersion across strategies. However, across these varied asset classes there is a consistent theme: transaction volumes are low because the majority of asset owners aren’t willing to transact at current valuations, and instead are waiting for more benign valuations, financing terms, and capital markets opportunities. The assets that are being sold tend to be at opposite ends of the quality spectrum: either Trophies or Trash.

• Trophies: The rationale for selling the trophies is to achieve the highest valuation possible to provide the most liquidity to buffer the remaining holdings. SoftBank sold its majority stake in Fortress Investment Group at a valuation of $2 billion, and BREIT sold an interest in The Bellagio Las Vegas for $950 million. Private Equity funds have been selling these assets to generate liquidity and keep multiples high.
• Trash: The rationale for selling trash is to insulate portfolios from further losses if a less-than-soft landing occurs and/or to improve regulatory treatment and reduce shareholder uncertainty. Capital One sold a $900 million portfolio of New York-office backed CRE loans, and Goldman Sachs has sold $2 billion of unsecured consumer loans through July of this year. Both sales were to distressed specialists.

As noted, the current market consists of varied crosscurrents, some of which are driving valuations higher and others that are pulling valuations lower. Some highlights across asset classes are in the table below.

In assessing these market conditions, we remain excited about deploying fresh capital. Across almost all asset classes where transactions are taking place, they are occurring at lower valuations, with enhanced structural protection, and/or at lower leverage. As has been the case over the last several quarters, investors with capital to deploy have a large opportunity set. Opportunities in secondaries remains robust, and the number of funds we consider to be seasoned primaries has expanded dramatically. (Seasoned primaries are often funds that have struggled to raise capital in the typically allotted 12 months and have asked Limited Partners for an extension to raise more capital). If these extended funds made investments early in their investment period, investors now have the opportunity to assess business quality and participate in any markups that have occurred since investment. Lastly, the distressed opportunity set is continuing to expand. Distressed investors have been active in both acquiring low quality at meaningful discounts and acquiring high quality at lower discounts, particularly non-recourse seller finance asset portfolios from the regional banks. We expect that deployment volumes will increase materially into year end and throughout 2024.