Quarterly Perspectives

October 1, 2023

Equity and bond markets declined in the third quarter, pressured by rising interest rates, which threaten the durability of the U.S economic expansion. The Federal Reserve continued its campaign of rate increases during the quarter, but at a slower pace and signaled its determination to maintain restrictive policy to ensure inflation does not reaccelerate. The history of business cycles suggests that the monetary tightening over the last eighteen months will make an economic slowdown hard to avoid, warranting defensive positioning in investment portfolios.

Economic Backdrop

The U.S. economy accelerated in the third quarter, supported by a strong labor market and a resilient consumer. Household spending, especially at the upper-income levels, remained robust through the summer months. Attractive yields on cash and record levels of net worth have bolstered consumers’ ability to absorb higher prices. Many households and corporations locked in low borrowing rates over the last few years, cushioning the full impact so far of higher financing costs. Recently passed government programs prompted new business investment with projects in the energy, semiconductor and transportation areas, a trend that will play out over many years.

Labor statistics continue to show notable strength and the unemployment rate of 3.8% remains near a record low. The economy is benefiting from an increase of workers entering the labor force including an influx of immigrants. However, demand for labor is now normalizing from unusually high levels with fewer job openings and easing wage pressures. In spite of tempered wages, inflation overall rose during the quarter with a jump in oil prices modestly boosting the U.S. Consumer Price Index to 3.7%, but it remains well off its peak of 9.1% last year. Overseas, the economic landscape is more precarious. European purchasing managers surveys signal contraction in many previously sturdy economies. The export-oriented region remains highly sensitive to higher energy prices and global demand, including that from China, which is experiencing its worst growth in decades. China, like Europe, is challenged by slumping exports but is mired in a broader range of issues including an ailing property market, onerous debt loads, high youth unemployment and dismal consumer confidence. Additionally, the country risks losing export market share to other Asian and Latin American nations. On balance, economic conditions are favorable in the U.S. but weakness abroad and the cumulative impact of monetary tightening are likely to weigh on growth in the period ahead.

Artificial Intelligence

ChatGPT became the fastest-growing consumer application in history, amassing 100 million users just two months after its launch in November of 2022. The stunning success of the artificial intelligence program focused investor attention on the technology and incited a wave of business investment. The primary beneficiaries of this spending today are the enabling hardware components, in particular, semiconductors. Long-term, AI will permeate every domain with profound implications for the economy. Client portfolios are exposed to a number of businesses that are positioned to participate in the technology’s widespread deployment. Semiconductor equipment suppliers are playing an increasingly important role in the manufacturing process as chips grow in size and complexity. Electronics connectors are benefiting from their higher content in AI servers. Public cloud vendors are seeing consumption growth fueled by AI workloads. Digital shopping and advertising platforms are offering more relevant recommendations. Enterprise software platforms are embedding AI into their applications and charging a premium for enhanced functionality. For example, software developers can complete coding tasks twice as fast using AI augmentation. Financial services firms are leveraging AI to improve their risk management processes, life sciences companies are preparing for accelerated advancements in drug discovery and industrial businesses are streamlining operations with automation and predictive maintenance. Across all industries, companies are engaging with consulting firms to guide them through the fast-evolving technology landscape.

Despite the initial enthusiasm for AI, mainstream enterprise adoption is likely to be slower than the rapid consumer embrace of ChatGPT. The large language models that underpin AI remain imperfect, burdened by slow processing speeds, inaccuracies, and concerns around cybersecurity, privacy, and ethics. Many businesses need to further modernize their technology systems in order to extract value from their proprietary data. There are unsettled debates around what role regulation should play as the technology evolves. However, extrapolating the recent rate of improvement of these models reveals a future of ubiquitous AI producing important economic benefits. As a productivity mechanism, AI holds the potential to dramatically increase living standards around the globe and will be a central investment theme for years to come.

Fixed Income

The rise in interest rates pressured bond returns, as yields on ten-year U.S. Treasury notes climbed from 3.8% at the start of the quarter to 4.6% in Septem- ber. Rates were lifted by an uptick in inflation, stronger economic data, an increase in the Fed’s policy rate to 5.5% and growing expectations of that rate remaining elevated for longer than previously forecasted. Other factors contributing to the rise in bond yields include the Fed’s operation to reduce its bond holdings and a growing U.S. budget deficit. The government must issue massive amounts of debt to fund the shortfall and investors are demanding higher yields in response. Further, fiscal borrow- ing is unusually high for a period of such low unemployment, and the prospects for reduced deficits appear limited. The yield curve has now been inverted for more than a year, with rates on short-dated issues exceeding those of longer maturity. The differential has recently narrowed, a typical development in the later stages of the business cycle. In client fixed in- come portfolios, we continue to focus on high-quality municipal, corporate and U. S. Treasury bonds to minimize the potential for credit risk. With the increase in yields to their highest level in sixteen years, we are further extending the average duration of bond holdings to lock in attractive rates.


Most stock indices fell modestly in the third quarter. The S&P 500 retreated -3.3% for the three-month period but remained solidly positive for the year. Stocks slumped in the wake of higher interest rates, which reduce the present value of a company’s future cash flows and lessen the appeal of equities relative to bonds. Investors are also weighing the risk to corporate earnings from the lagged effects of Fed policy, contraction in the money supply and tighter bank lending standards. Client portfolios remain defensively positioned in the near term as economic stresses are emerging in elevated credit card delinquencies, rising small business bankruptcies, weakness in certain areas of discretionary spending and sluggish housing market activity.

Consumer behavior may be further vulnerable to rising gas prices, student loan repayments, labor strikes and waning excess savings accumulated during the pandemic. Despite the potential for an economic slowdown, the long-term prospects for equities remain quite constructive. Corporations have adapted their business models to the complex operating environment, including volatile input prices. Secular trends, such as artificial intelligence, are poised to raise corporate productivity and profits over the long term. Valuations for most stocks are quite reasonable compared to historical averages, suggesting that a degree of economic risk is already priced into certain equities. We remain committed to our process of identifying high-quality businesses with superior growth and profitability, while being mindful of extended valuations in some pockets of the market. Any potential market correction will be used as an opportunity to add new equity holdings that meet our stringent criteria for long-term growth potential.