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Q3 Turned Out to Be a Tough Quarter for Markets

Friday marks the end of Q3 (for markets). As we take a look at bond and stock portfolio returns, we see that it’s been a tough quarter for investors.

Long term interest rates increased to 4.57%

10-year Treasury rates had fallen all the way back to below 3.4% earlier this year. However, Q3 has seen rates (especially long-term 10-year bond rates) increase persistently – ending the quarter at almost 4.6% (chart below, dark green line).

That’s also their high since 2007 – right before higher rates caused the credit crisis and a recession – that led to rapid rate cuts.

Treasury yields

So what made this happen?

Fed shift to higher-for-longer rates

Prior to Q3, markets were optimistic that inflation and spending would slow enough that the Fed could begin cutting rates at the end of this year.

However, as Q3 has progressed, we saw continued economic resilience: unemployment remains below 4%, layoffs have failed to materialize, and consumer spending keeps on keeping on.

That has caused the Fed to see that rates aren’t working to slow the economy yet…allowing them to keep rates higher for longer – including in the “dot plot” that the Fed published after their latest meeting. The latest dot plot showed them increasing their end-2024 Fed funds rate projection 50bps to 5.25% (from its June estimate, chart below, purple circles).

We can see the impact of this in the charts above and below:

  • In the chart above, we see long-term rates increasing faster than short-term rates, with the 2-year Treasury rates “only” rising about 20bps in Q3 (light green line).
  • In the chart below, which looks at the markets expectation for short-term rates in the future, you can see the peak rates have hardly changed (peaks in light vs dark blue lines). However, the expected rate at the end-2024 rose 90bps since June to 4.9% (dark blue line), and the end-2025 expectations rose 55bps to 4.4%, pushing up 10-year rates.
Market expectations for Fed Funds rate

Higher long-term rates hurts equity valuations too

Typically, when interest rates rise this much, stock prices also fall, since higher rates not only hurt demand, but also add to borrowing costs for corporates, both of which are bad for earnings. Remember that’s what we saw in 2022 when the Fed was consistently hiking interest rates.

After a great first half – the Nasdaq 100 had its best first half ever and the S&P 500 was up nearly 20% YTD early in Q3 - the end of Q3 saw the S&P up just 12% for the year (chart below).

YTD S&P 500 performance

However growth stocks weren’t hurt by higher rates as much as you’d normally expect

If we look at sector & style performance in Q3, what we see is interesting. Normally when interest rates rise – tech and growth stocks would fall. This quarter, however,

  • Communication Services (which includes big tech like Google and Meta benefited from AI optimism)
  • Growth stocks outperformed value (helped by the AI trade)

Looking at the best and worst sectors we see:

  • Energy benefited from the 40% increase in oil prices this quarter
  • Real estate and utilities performed worst (real estate is “rate sensitive” as rents on a building act similarly to interest on a bond)
Q3 returns by sector

As we enter Q4 what should we watch?

Some are talking of 10-year rates hitting 5%. But if we keep seeing just 0.1% per month in core inflation (like we got today) it’s hard to see the justification for more rate hikes. Note that interest rates are now above inflation rates for the first time in a long time.

Then there is the triple whammy of shocks we discussed last week (student loan repayments, government shutdown, and the ongoing UAW strike). Plus, now, higher oil prices.

Although pretty soon we’ll have Q3 earnings to look at too, and consensus seems to have them improving again – which will help market. Stay tuned!

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