Investors Face Growing Challenges as Fourth Quarter Approaches

As we approach the fourth quarter, investors find themselves confronted with an expanding array of challenges, which continue to grow in magnitude. These challenges range from the escalation of interest rates to the potential resurgence of inflation and the political deadlock in Washington, all of which could potentially hinder economic growth.

The Federal Reserve, adhering to its course of raising rates, is now less likely to reduce borrowing costs in the coming year, deviating from earlier expectations. The specter of oil prices soaring to $100 per barrel, coinciding with an increase in strikes orchestrated by the United Auto Workers union, is rekindling concerns regarding inflation. Meanwhile, factors that could potentially put the brakes on economic growth, such as the looming threat of a government shutdown and the resumption of student loan repayments, may prove insufficient to deter the Fed's determination to combat inflation.

These factors cumulatively contribute to an increasingly formidable array of concerns for many investors and traders, who had anticipated a decline in inflation and the conclusion of the Fed's interest rate hikes. With the central bank's primary interest rate target already at its highest point in 22 years and projected to climb further by December, Treasury yields have reached levels not witnessed in over a decade, capping the potential for further gains in equity markets and necessitating a quest for protective measures.

Following the Federal Reserve's policy update, which emphasized a commitment to maintaining higher rates for an extended period, strategists at JPMorgan Chase & Co., the largest U.S. bank, noted that their pessimistic outlook for equities was gaining significant traction. They also pointed out that September through mid-October historically represents the most bearish period for risky markets from a cyclical perspective when compared to the current situation, even drawing parallels to 1987, the year of the "Black Monday" crash. However, they stopped short of predicting a full-blown market crash.

The surge in market-implied rates subsequent to the Fed's announcement has given rise to a situation characterized by "more losers than winners," in the words of portfolio manager Christian Hoffmann at Thornburg Investment Management, with both equity and bond prices experiencing declines.

On the subsequent day, all three major U.S. stock indices, namely the DJIA, SPX, and COMP, concluded the day with losses for the fourth consecutive day, resulting in weekly losses that eroded their year-to-date gains. Concurrently, Treasury yields remained close to their highest levels since 2006-2011, as futures traders of fed funds priced in a 40.7% probability of further tightening by the Fed before the year's end.

Nonetheless, some analysts maintain a sense of optimism. Jeffrey Cleveland, chief economist at Payden & Rygel in Los Angeles, which manages assets exceeding $144.4 billion, expressed that "higher rates for a prolonged period are not necessarily detrimental if the Fed remains committed because economic growth is robust." He emphasized that the economy is performing better than expected, which has prompted adjustments in interest rates. This, he noted, could actually benefit the riskier segments of portfolios, including high-yield corporate bonds.

Cleveland emphasized the strength of the economy, suggesting that most investors should be able to overcome their concerns and uncertainties without encountering insurmountable obstacles. He opined that the momentum is sufficiently robust to enable investors to surmount this "wall of worry," and he added that the U.S. economy is unlikely to plunge into a recession within the next 12 months.

However, even Fed Chairman Jerome Powell isn't entirely convinced that the U.S. can achieve a gentle landing and evade a recession, despite policymakers' hopes for such an outcome. This skepticism is apparent in their growth, unemployment, and inflation projections until 2026. The forthcoming release of the personal consumption expenditures price index, the Fed's preferred measure of inflation, is a data highlight for the upcoming week. The July report indicated that both headline and core inflation rates remained stubbornly above 2%.

Presently, the world's largest economy appears to be undergoing a "controlled landing." In this scenario, the labor market remains healthy but is cooling, wage growth is moderating, and both consumers and businesses are exhibiting cautious spending tendencies. Gregory Daco, chief economist at EY-Parthenon, the global strategy consulting division of Ernst & Young in New York, suggested that his firm anticipates real GDP growth of 2.2% in 2023 and a more subdued 1.3% in 2024.

Daco emphasized the likelihood of a protracted era of higher interest rates and advised adapting to this new paradigm. He stressed that every portfolio is unique, with its own set of risk objectives and return goals. Therefore, the key lies in understanding one's risk tolerance and devising strategies to maximize returns in an environment characterized by elevated capital and equity costs.