In the third quarter of 2023, several key factors influenced financial markets. The commitment of the Federal Reserve (Fed) to a prolonged level of higher interest rates gained further acceptance among market participants, investor sentiment towards growth stocks cooled, and energy prices surged.
These combined factors had a noticeable impact on various fixed income segments, with most of them experiencing a decline of close to 3% in the third quarter. Notably, high yield bonds stood as the exception, managing to deliver a slightly positive return. Equity markets offered few places to hide.
Among S&P 500 sectors, a reversal of fortunes was apparent. Energy emerged as a standout winner while sectors, such as information technology, that had previously shown strong performance, faced headwinds.
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One of the key tenets of TD Wealth's investment philosophy is diversification. Performance over recent quarters reinforces the importance of having exposure to a diversified set of sectors because it is very hard to know which sectors will outperform or underperform in any given period.
In the third quarter of 2023, we also saw increased volatility, especially in longer-term yields. There has been a notable shift in expectations regarding the trajectory of monetary policy, with market participants now accepting higher for longer interest rates. An uptick in the supply of Treasuries has also pressured yields, while persistent strength in the labor market and consumer spending is keeping inflation sticky.
As a result, we don't anticipate a significant decline in longer-term yields until we observe a sustained moderation in labor market conditions.
On the bright side, higher yields are assisting the Fed by tightening financial conditions, a fact acknowledged by some Fed members, and we anticipate the Fed is nearing the end of its rate hiking cycle. While a 25 basis point increase in the fed funds rate remains a possibility before the end of the year, we expect the Fed to subsequently stay on pause until the second quarter of 2024 before considering rate cuts.
Conflict in the Middle East has served as a reminder of how quickly geopolitical risks can emerge. While we hope for a swift resolution to the current conflict, events such as these have historically pushed energy prices higher and stabilized once a resolution has been reached.
Shifting to equities, although valuations as measured by the price-earnings multiple have improved from peak levels earlier in 2023, they remain elevated, exceeding their long-term averages. Additionally, when considering the equity risk premium, equities still appear relatively expensive compared to bonds.
Looking forward, we anticipate the Fed will maintain higher rates for an extended period, and weaker economic conditions will have repercussions for both the consumer and corporations. From an asset allocation perspective, we continue to favor fixed income over equities, with the expectation that fixed income will likely outperform over the coming 12-18 months.
Within fixed income, we remain focused on higher quality bonds and selective in credit. In equities, we lean toward large cap companies over small cap and maintain a preference for domestic equities over international and emerging markets.
We believe it's important for investors to stay in the market over the long-term but also consider ways to make volatility work for them. Dollar-cost averaging, for example, may be a great way to take advantage of short-term fluctuations by investing smaller amounts on a regular basis and compounding gains over time.
Investors not only have an opportunity to leverage periods of near-term market volatility but also to improve the likelihood of achieving their long-term financial and life goals.
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