Third Quarter Review: "Higher for Longer"

In the third quarter, stocks and bonds fell modestly as a resilient U.S. economy forced investors to change their expectations for future interest rate cuts, reducing demand for stocks and long-term bonds. Cash and short-term bonds were seen as safer choices. Commodities bucked the broader trend with oil prices rallying due to lower global inventories and production cuts by Russia and Saudi Arabia.

Nevertheless, most types of stocks had positive returns over the past year (figure 1). In fact, many clients may be surprised to learn that the return on international equities in developed countries eclipsed that of the U.S. market.  

Figure 1

 A Renewed Focus on Deficits

Heading into the quarter, the yield curve—a graph plotting interest rates for bonds of different maturities— showed lower interest rates in the next 1-2 years. The Federal Reserve’s (the Fed) decision to hold interest rates steady at its June meeting seemed to reinforce the narrative that inflation was coming under control and cumulative rate increases were having the desired effect in cooling the economy.  

But in late July, the U.S. Treasury announced it would need to borrow more than expected in the third quarter. While the U.S. government frequently runs annual budget deficits (financed by issuing debt), 2023’s was unexpectedly large.  

Several reasons contributed to this: For starters, 2022 was a down year for financial markets, so tax receipts tied to capital gains understandably declined. Delays in revenue collection also played a role: the IRS granted taxpayers in several states (including most Californians) an extension for filing 2022 returns following natural disasters and severe weather events. On the other side of the ledger, increased spending on defense, infrastructure, social programs, and higher interest costs for financing the national debt expanded the budget shortfall.  

This increased deficit and a resilient job market made investors worry that the Fed would continue raising rates or, at the very least, hold them “higher for longer.” The result was a “bear steepening” of the yield curve, whereby the last few months saw a continuation of the defining trend of the past 1-2 years: a relentless rise in interest rates.

Figure 2

Source: Calculated Risk

Arguably, a steepening yield curve is doing some of the Fed’s work for it and may have influenced the decision to hold interest rates steady once again at its September meeting. Many consumer loans for mortgages, autos, and credit cards are increasingly expensive, effectively restraining spending. 

A Silver Lining for Bond Investors

The past few years have been among the worst on record for bond investors, particularly those exposed to bonds most sensitive to changes in interest rates (measured by the average maturity or ‘duration’ in a bond portfolio). For perspective, we can compare the returns of bond funds of varying duration since the commencement of the Fed’s rate increases in March 2022 (figure 3). The Vanguard Ultra-Short Bond fund has the lowest duration on this list (0.93) and was the only fund to generate a positive total return. The overall bond market and funds with longer average durations suffered losses proportionally. 

Figure 3

Starting several years ago, when low interest rates prevailed, we anticipated little upside and significant downside risk in holding the typical intermediate index bond fund. We started making incremental adjustments to our clients’ portfolios in two ways. First, we emphasized high quality, shorter duration, and actively managed bond funds. Second, we reallocated some of our traditional bond investments into what we labeled “Other Assets” on your quarterly statement. We felt that these alternative strategies, such as merger arbitrage, tactical fixed income, and fixed-to-floating preferred stock, offered a greater likelihood of positive returns, with modest downside risk, during a period of rising interest rates. 

This tactical shift worked well, as our fixed income and “Other Assets” segments outperformed the overall bond market for the past few years.  However, 18 months into the Fed’s monetary tightening, we’re now in a situation where high-quality short-term bonds offer yields exceeding 5%, better than they have in over a decade. Accordingly, we’ve begun to reverse the shift we made a few years ago and likely will continue to do so.   

Large Cap Value Review

(Not all clients of Bristlecone are invested in our Large Cap Value (LCV) equity portfolio strategy, depending on the overall portfolio size and the client’s objectives and constraints).

Our Large Cap Value portfolios declined slightly more than the S&P 500 and Russell 1000 Value index during the third quarter.  While growth stocks did a bit worse than value stocks on average, they remain the best-performing part of the market year-to-date by far, particularly among larger companies. The U.S. stock market remains unusually concentrated in a handful of mega-cap tech stocks (for more, see our “Magnificent Seven” comments in the 2nd quarter review). One way to visualize the impact of this concentration is to compare the returns of those “Magnificent Seven” companies to not just the overall S&P 500 index performance but also to an equal-weighted S&P 500 index (figure 4) where every company in the index has the same weight. 

Figure 4

 While the S&P 500 index finished the quarter up 13.1% YTD, substantially all this outperformance came from just the top 10 stocks. Note that the equal-weighted version of the S&P 500 is lagging the average money market fund YTD! Moreover, those top 10 stocks now trade at about a 50% valuation premium to the rest of the stocks in the index (figure 5). How long investors will tolerate a 3.8% earnings yield on mega-cap stocks when money market funds yield over 5% remains an open question.

 Figure 5

Source: JP Morgan Guide to the Markets, 9/30/23

Over the past several weeks, we initiated a new position in the LCV portfolio, a specialty auto insurance company named Hagerty (HGTY). This company became public in late 2021. We were intrigued to learn that one of its top shareholders is another specialty insurance corporation we are familiar with: Markel (MKL), a business with an excellent investment track record, whose shares we’ve owned since 2009. 

As it turns out, Hagerty occupies an exciting and lucrative niche—insuring collectible vehicles.  Insurance for classic cars and motorcycles differs in two crucial ways from everyday vehicles: lower losses and higher customer retention. Hagerty is the industry leader in this niche, with a database going back decades, giving the company pricing advantages in writing premiums. In the U.S., it continues to take market share from traditional auto insurers. Finally, the company is building several attractive ancillary businesses such as classic car auctions, Concours d ’Elegance, roadside assistance, and an online valuation database.  

In short, Hagerty has an underappreciated path to long-term growth while the stock trades at an attractive multiple of its potential earning power. At the current market cap of less than $1 billion and with an even smaller free float of publicly traded shares (over 90% of the company is held by the founding family and a pair of strategic investors), this is not a stock likely to be included in the S&P 500 index anytime soon…and that’s OK with us.

As always, we welcome any questions or comments you may have and appreciate your confidence in our services.