Next Steps

September 2023



We are almost through September, which historically has been the worst-performing month, on average, since the end of World War II.

Last month we pointed out that a pullback was likely in the near future, given the recent run in the broad market. Well, we got it — the S&P500 is down about 5% month to date, as of filming.

So, as we head into the final quarter of 2023, what lies ahead and how are we preparing to shift or adjust our outlook? Let's cover that this month.

We'll start with stocks — we continue to favor U.S. equities: That hasn't changed, and we expect that U.S. economic and earnings growth will remain more resilient than global alternatives. Year to date, U.S. outperformance continues to be significant, but when do we plan to increase stock exposure?

We are planning to opportunistically increase equity exposure when reward risk warrants in anticipation of a recovery in corporate profit growth in the second half of 2024. Timing will depend on three key equity conditions.

Chart 1: 1:19 — 1. Earnings: Recall, we have been relatively cautious about near-term earnings and margin growth. We still think consensus estimates are not properly pricing in a slowdown, whether it's a soft landing or a mild recession.

Going into next year, we expect margins and earnings to come under some pressure before improving.

As depicted here, the second half is estimated to see a recovery. As our confidence in recovery grows, so will our willingness to increase stocks.

Chart 2: 1:50 — 2. Valuations: While the recent pullback has improved the valuation in the broad market, we are still not in the fairly priced range. Lower index levels or higher earnings are needed to get us in a more attractive valuation range.

3. Volatility: Volatility remains above normal comfort levels, and durable market returns are usually associated with sustained periods of lower volatility.

Shifting the bonds: Today's higher bond yields offer the most attractive opportunities for investors in over a decade. Interest rates across the bond market remain elevated, despite declining inflation. We do not believe it is time to add exposure to longer maturity bonds just yet, but it is getting closer.

Short maturity bonds are currently providing ample income. Longer maturity bonds are expected to remain volatile and, we believe, will trend higher near the end of the year. For clients investing in tax-exempt fixed income, as municipal yields rise, so does the value of the tax exemption. Attractive levels of Q1 income help buffer volatility and improve forward return expectations.

Further, lower correlation versus other asset classes has provided diversification benefits with resilient quality characteristics. For higher-yielding bonds, our fair-value model for high-yield spreads is showing that risk may be mispriced. Currently, the model is suggesting that spreads could widen from here.

To sum up, given the combination of Federal Reserve policy at, or near, peak; the downward glide path in inflation; and, most importantly, the removal of normal recession risk, we are preparing to overlook the modest recession value ahead.

The timing of increasing equity allocations will depend on three key equity conditions. We think opportunities to extend duration and fixed income are coming, and, of course, actual client outcomes will be determined by intelligent personalization and individual portfolio goals.

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