Both U.S. stocks and U.S. bonds declined in October, falling by 2.3% and 1.3%, respectively. The magnitude of these losses is not uncommon. Fluctuations of this sort are historically par for the course. The economic backdrop to these losses, however, stands out.
First, let’s discuss the U.S. labor market. Comparing present day data with data from 2000 through 2019, we clearly see strength in the present. On a broad level, initial jobless claims are presently the lowest they have been when compared to the twenty years prior to the pandemic. That’s occurred alongside an impressive number of jobs still unfilled. To be sure, the number of unfilled job openings has declined to 9.6 million in recent months, but that still leaves us with a whopping 2 million more job openings than at any time in the two decades prior to the pandemic.
The broader economy surprises, too. A report from the Bureau of Economic Analysis showed that gross domestic product grew at an inflation-adjusted annual rate of 4.9% during the third quarter. This result is remarkable for two reasons. First, this is a degree of expansion that is approximately double any quarterly growth rate seen since the post-COVID rebound of 2020 to 2021. Double! The average growth rate forecasted three months ago in a Wall Street Journal survey of economists was a mere 0.6%, with none of the 68 forecasters predicting anything higher than 3.2%.
With a seemingly unstoppable labor market and an economy that’s defied recession expectations, why have most financial markets declined since July? At the risk of sounding like a broken record, the most likely explanation is still interest rate increases. As the economic expansion relentlessly marches on, expectations of a near-term recession and corresponding interest rate cuts from the Federal Reserve have dissipated. If the Federal Reserve isn’t cutting interest rates, it is leaving them at their current elevated level or increasing them still. Since the latest yield paid by the U.S. government is used to discount future cash flows, the expectation of higher rates drags down the price of stocks and bonds.
There is a silver lining to this. While higher rates suppress asset prices, they also tend to reward us with higher future returns. Since prices were reduced but the underlying cash flows haven’t changed, the return on investment going forward should be higher. Take an example. In the summer of 2003, an index of long-term U.S. treasuries declined by 11% in a just two months as the yield on a 20-year bond went from 4.4% to 5.3%. However, investors who stayed the course were rewarded with a return of 14.4% over the following three years. It would be nice if strong economic conditions immediately rewarded investors, but investment success almost always requires patience. Investors with a forward-looking view will enjoy the rewards to come.
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