IMG Q3 2023 Investor Letter

US Economy

We started the third quarter encouraged that the Fed was nearing the end of its hiking cycle. After leaving rates unchanged in June, the first pause after lifting them at 10 straight policy meetings to combat inflation, the Federal Reserve reinitiated its monetary tightening campaign in July with a 25 basis point increase. This brought its benchmark interest rate to a range of 5.25% to 5.50%, a 22 year high. The Fed then hit pause on interest rates at its September meeting but left the door open for at least one additional hike in 2023.

Inflation continues to trend downward as rate hikes work their way through the broader economy, but it still remains well above the 2% target. The consumer price index (CPI), which measures the overall change in consumer prices, ticked up from 3.3% in July to 3.7% in August compared to a year earlier. However, the core CPI, which excludes volatile components like food and energy, fell from 4.7% in July to 4.4% in August compared to a year earlier. For context, the CPI peaked at 9.1% for the year ending June 30, 2022, the largest increase in 40 years. Still, the fact that inflation has come down does not mean prices have come down. Prices for many items, though rising more slowly this year than last, remain well above pre-pandemic levels and are not likely to return to where they were. While this permanent shock to the price level may sour consumer sentiment (consumer confidence declined in August and fell again in September), it has not affected their willingness to spend.

So far in 2023, robust consumer spending and historically low unemployment have supported solid U.S. economic activity despite rising interest rates. Americans spent 5.8% more in August than a year earlier.

Consumers may not be able to splurge forever. Higher gas prices and the resumption of federal student loan repayments may curb spending. When the Education Department paused loan repayments in March 2020 to help cushion the financial effects of Covid-19, it empowered people to spend money on other things as the economy rebounded, fueling economic growth. The restart on October 1st could divert roughly $100 billion from Americans’ pockets over the coming year.

Elsewhere, many Americans are dipping into savings. The personal saving rate, a measure of how much money people have left each month after expenses and taxes, declined for the third consecutive month and hit 3.9% in August.

Labor strikes and a potential government shutdown could at least temporarily curtail the spending power of some workers. Historically low unemployment and high inflation have spurred various labor unions to bargain more aggressively, winning big pay increases and better benefits in industries beset with worker shortages (UPS drivers, Delta and American Airlines pilots, and Hollywood writers, to name a few). The U.S. lost more than seven million workdays because of labor disputes this year through August, more than any full year since 2000. Moreover, this does not include the United Auto Workers strike that started September 15th. Whether these conditions persist is unknown since an economic downturn could deter enthusiasm for walkouts. However, missed workdays equate to missed paychecks and reduced spending.

With a federal government shutdown narrowly averted to close out September, legislators now have 45 more days to agree on a budget. Government spending is generally authorized one fiscal year at time; a government shutdown occurs when leaders cannot reach an agreement on government spending by the deadline. While this is completely separate from the debt ceiling and does not impact U.S. debt instruments, the risk of a government shutdown underscores the disparity around spending. Spending by the U.S. government is the highest it has ever been outside of wartime, and deficits are already very high. Earlier this year, Republicans, who have narrow control of the House, posed that raising the debt limit be accompanied by spending cuts. Political disorder is never welcome, and a shutdown could cloud the economic outlook (and interest rate decision) in the final months of the year since the closure of certain agencies could delay the routine release of fresh economic data on wages, employment, inflation and output.

Traditional Asset Class Returns Q3 2023

U.S. Stock Market Recap

Stocks pulled back in the third quarter, with the S&P down 3.3%, but year to date returns remain positive, up 13.1%. The technology-heavy Nasdaq Composite, which was up a startling 32.3% in the first half of 2023, declined in August and September, ending the quarter down 3.9%, but up 27.1% year to date. Historically, August and September are the two worst-performing months for the S&P on average since 1970.

Technology stocks tend to command higher valuations based on expectations that their businesses will expand far into the future. Given the higher for longer interest rate backdrop, higher rates erode the future worth of that anticipated growth. Of the seven companies (Apple, Alphabet, Meta Platforms, Microsoft, NVIDIA, Amazon and Tesla) that fueled most of the S&P 500's advance in the first half of the year, only Meta Platforms was positive in September.

All sectors declined in August and September save for Energy, which was up 1.8% and 2.6%, respectively. Energy stocks benefited from the rise in U.S. crude oil prices, which rallied after production cuts made by OPEC and its allies in early July reduced global oil supplies to a level below demand. Only Energy and Communication Services remain positive for the quarter, up 12.2% and 3.1%, respectively.

Consumer Staples (-6%) and Utilities (-9.2%) were the worst performing sectors for the quarter. These typically higher yielding defensive sectors may look less attractive on a relative basis to 12-month Treasury bills yielding more than 5%.

From a style perspective, growth stocks continue to outperform value stocks in 2023. Growth companies are generally expected to grow their sales and cash flows at a faster pace than the overall market. They can be young, unproven, volatile firms in innovative fields, many of which pay little to no dividend. Many of these firms operate in the Information Technology and Consumer Discretionary sectors. The Russell 1000 Growth index is up 25% year to date (after finishing 2022 down 29.1%), whereas the Russell 1000 Value index is up only 1.8% (after finishing 2022 down 7.5%).

Fixed Income

A resilient economy caused interest rates to climb through the third quarter as investors began to believe the Fed will achieve higher rates for much longer than initially anticipated to combat stubborn inflation. Although inflation has continued to cool year to date, it still remains higher than the Fed’s 2% annual target.

Short term rates moved 15-25 basis points (0.15%-0.25%) higher throughout the quarter, in-line with the rate hike by the Fed in July of another 0.25 percentage points to 5.25%-5.50%. In a reversal of trend from what we have seen over the last 12+ months, we finally saw the longer end of the curve (10 to 30 years) have the more prominent rate surges. This was fueled by continued strong domestic economic data, as well as impacts from other global central banks such as the Bank of Japan (BOJ). The BOJ announced it was lifting the hard limit on its 10-year bond yield which could ultimately result in lower demand of U.S. Treasuries from international buyers looking to avoid currency risk. If the supply of U.S. Treasury securities begins to outgrow domestic and international demand it can lead to higher long term rates. The 10-year U.S. Treasury hit a 15 year high in August and ultimately ended the quarter at 4.57%, 74 basis points or .74% higher than the end of the second quarter.

While bond yields move inversely to prices, higher interest rates help to provide a cushion to offset some of the negative price return. Investors did experience absolute negative returns for the quarter; however, on a year to date basis returns of the U.S. Government and Credit sectors with short to intermediate durations are slightly positive. The broader U.S. Aggregate bond index with a longer duration remains negative year to date. High Yield continues to be the strongest performing sector, returning 5.86% year to date.

As it appears the Fed is further away from any interest rate cuts, we will continue to closely monitor portfolios and use this period of heightened interest rates as an opportunity to boost income. It is difficult to imagine that only a short time ago the world was witnessing trillions of dollars invested in negative interest rates and the 10-year U.S. Treasury was at an all-time low yield of 0.51% in August 2020.

We have maintained a disciplined process throughout this interest rate cycle and will continue to do so in order to achieve strong fixed income returns regardless of the interest rate environment.

Diversifying Asset Classes

MLPs was the sole standout diversifying equity asset class in the third quarter, up 9.9%. Most other diversifying equity asset classes posted negative returns in the third quarter. Still, Emerging Markets (-2.93%) and Managed Futures (-2.48%) outperformed the S&P 500 in the quarter.

Among diversifying fixed income asset classes, Floating Rate and High Yield bonds added significant value in the second quarter, whereas Emerging Markets debt and Long bonds underperformed the Bloomberg U.S. Government Intermediate index in the quarter.

Conclusion

Despite rate hikes and sticky inflation, we continue to see economic strength and positive returns across major asset classes through the first half of 2023. Moreover, the positive performance has begun to expand beyond the seven mega cap technology companies that drove the bulk of gains through May. Ongoing elevated inflation and uncertainty around the Fed’s future path may continue to cause volatility in the markets. We plan to help you meet your long-term financial goals in all environments and encourage you to stay the course.

Sincerely,

David B. Smith, CFA

Managing Director and Chief Investment Officer