Chris

Sam, as I look back on the third quarter, it seems to me that the dominant headline was the bond market, and in particular the rise in Treasury yields. And as an equity investor, when the bond market's in the news every day, that's not really a good thing. But we saw 10-year Treasury yields trade at the highest level they've been at since 2002, and throughout the quarter, there were a number of reasons that people pointed to for why yields were going up. I think it started with the U.S. debt reaching $40 trillion, as you and I have talked about in the past. That's a number. That's all it is. But it generated a fair number of headlines when it happened. Interestingly, AI infrastructure buildout seems to be kicking in and having an accelerating impact on the U.S. economy. And third-quarter GDP estimates are higher than they were for the first half of the year that we saw. So that's a good thing. But of course, the dominant headline was increased military action in the Middle East, another run-up in oil prices, the impact that's having on inflation data, and of course, a new chair at the Fed who has put inflation in his crosshairs and made it clear that they're going to figure out how to bring that down. So, from your perspective, what's going on in the bond market?

Sam

Yeah, that’s a great question, Chris, and certainly very timely. I feel like I'm more popular now than I've been since probably 2022, that's for both good and bad reasons I would argue, right? As you kind of alluded to, I think there's been a variety of factors that's kind of contributed to the rise in long-term and short-term interest rates that we've seen over the past couple of months, and those factors, you know, some of them I think are encouraging, some slightly less encouraging. But over the long run, I think what I take away from it is that markets have ultimately held up relatively well, given the variety of risks that we currently face, right. As you mentioned, the geopolitical uncertainty has really impacted the energy outlook and the inflation outlook, and I think that's one of the drivers of the higher rates that we've seen. But much more encouragingly, the continued impressive resilience of corporate America and the demand for this AI-driven investment has really, I think, kind of created an expectation for a significant amount of growth in the future that also is contributing to the higher yields that we've seen, right. So, some positive news, some slightly less positive news. But, ultimately, markets have held up relatively well despite the rising risks that we've seen.

Chris

Yeah, and certainly the equity markets have held up well. The reason I said equity investors usually don't like the bond market to be in the headlines is it's usually hard for stocks to go up when interest rates are moving higher. We saw that in 2022. But if you pick up your paper or watch the news, you see that the S&P 500 and the Nasdaq are trading at all-time highs, and that's true. But we're back in this environment where a handful of stocks are doing all the work. The large growth companies that are levered to AI have had great performance, but interestingly, more than half the stocks in the S&P are off 20 percent from their all-time high. So, the breadth we had in the market that helped drive performance in the first half has really dried up as rates have increased, particularly for financials and then things like utilities and real estate. But I always say when things like that happen, there are opportunities. I would assume the same's true on the fixed income side. You see a big move up in yields, there has to be some opportunities for investors or people looking to generate income, and I'm curious where you think those opportunities are currently.

Sam

I think that's kind of the silver lining of this volatility that we've seen is that going forward, fixed income investors and especially those who are relying on the income generation potential in fixed income really have a pretty compelling opportunity set, in my opinion. As you mentioned, long-term Treasury yields, which are typically viewed as one of the safer areas in the market, are at levels that we haven't seen in decades, right? And this allows savers or retirees to invest and generate really, in my opinion, compelling levels of income without taking on high levels of credit risk, right? That's something we haven't had as an opportunity set for a number of years now. There's other areas that I think are relatively attractive as well. But ultimately, when it comes to fixed income investing over the long term, the best determinant of total return is your initial yield that you invest at, right. So, with higher yields now, you know, theoretically creates higher opportunities and potential for higher total return opportunities, especially for those who can be a little bit patient and wait out the short-term volatility.

Chris

Right, and I think we could be setting up a similar environment in the equity markets because as we enter the second week in October, we're about to start earnings season. And right now, consensus estimates are that S&P 500 earnings growth for the third quarter is going to approach 30 percent, which is a stunning number, and it would be the third straight quarter of 25 percent earnings growth for the index. Now, obviously, as the bar gets raised, it does set up for potential disappointments. But what's interesting to me, with half the market down 20 percent from its all-time high, is that there are expectations that all 11 sectors will generate earnings growth in the quarter, 5 of those sectors will generate double-digit earnings growth, and if we strip out the big companies that drive the index performance, the rest of the 490 names in the index are still expected to generate earnings growth in excess of 20 percent. So, I think this will be a really key earnings season to see if we get rotation back into the rest of the market, breadth improves, and we return to the market environment where value was outperforming growth, small cap was outperforming large cap. Or, if rates continue to move higher, whether the market stays narrow. But it sounds like to me that in a 60/40 portfolio, the potential for opportunities on both sides of the portfolio are setting up quite nicely.

Sam

I think for well-diversified patient investors, the current opportunity set seems to be relatively attractive and relatively compelling, with the caveat that we could certainly see more short-term volatility. But I think it really makes a case for diversification. And as you mentioned, like the 60/40 type of portfolio has performed relatively well this year. Which, if you had told me at the start of the year we were going to face all of these risks and all of these challenges, I would have thought both the economy and markets might be, you know, limping along a little bit less impressively than they have so far. So, I think the resilience in corporate America, the fundamentals being strong, and a still positive economic backdrop are really all combining to hopefully allow us to take some of these headwinds and, as we head towards the end of the year, turn them into tailwinds.

Chris

I couldn't have said it better myself, Sam. So I agree.

Sam

Well, thanks, Chris, for sharing your thoughts, and thank you for joining us. Join us again next month for another update from the Market Observatory.