After three quarters of strong returns lifted the S&P500 index, equities took a step back in Q3. It felt worse because there was a decline of almost 5% in September followed by a weak start to October. Much of the recent weakness can be pinned on an unusually strong global selloff in government bonds. Long-term bond yields ramped up during September and then jumped further in the first week of October. It seemed that equity investors discounted the move quickly, expecting rates to move higher and stay higher indefinitely. While long-term interest rates may have structurally shifted higher and will likely not return to the low rates of the past decade, we see the recent moves in both the bond and equity markets as excessive.
It is important to recognize that most economists, including the Federal Reserve Board, have significantly underestimated the strength of the underlying economy in 2023. And with the Fed continuing to focus on lagging indicators, they may now be overestimating inflation as well. There are many factors which can push long-term interest rates higher; however, inflation is the fundamental driver of long-term bond yields. We are encouraged by the path of inflation over the past year and expect further improvement over the next few quarters along with better-thanexpected strength in the underlying economy.
Higher bond yields make it more expensive for governments to refinance their own debt, so that takes money out of the economy. Higher long-term interest rates in the private sector will also make spending and investment more expensive thereby slowing the economy and providing a disinflationary impact.
Fortunately, our focus on free cash flow and dividend growth for the companies in our portfolios means interest rates will have less impact on their ability to grow. Strong balance sheets allow management teams flexibility to pursue the most favorable corporate strategies at exactly the time weaker competitors can’t respond. Investors should continue to benefit from consistent dividends and share buybacks - important factors to help support share prices.
We feel that these free-cash-flow-minded, dividend-growing management teams have demonstrated exactly the discipline that will allow them to maneuver successfully in the current uncertain environment. With a background of moderating inflation and a very solid job market, market analysts are currently expecting 2024 earnings growth of more than 10%. And while there is uncertainty, underlying stability allows quality management teams to take advantage of growth opportunities.
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