The third quarter began on an optimistic note but ended in disappointment for both stock and bond investors. As gasoline prices eased during the quarter, inflation appeared to have peaked. This gave markets hope that inflation would moderate shortly, allowing the Fed to moderate its hawkish monetary policy stance, making a case for a softer economic landing. Second-quarter earnings were reported lower than the previous year but were still strong despite the numerous economic headwinds. This provided optimism that the market might look past the economic slowdown, creating a short-lived bear market rally from July to mid-August for both equity and credit markets.
Then in late August, Jerome Powell gave his speech at the annual Jackson Hole conference. During his speech, he placed an emphasis on reducing inflation to the Fed’s long-term target of 2%, even at the cost of higher unemployment and possibly a recession. The clarity and sternness of his message brought the market calm to a halt. On September 13, the August Consumer Price Index (CPI) reading was much hotter than anticipated. The combination of these two events led markets to the realization that the threat of higher inflation would support the Fed’s action for further rate increases. The equity market’s response was a complete reversal, with US indexes making lower lows for the year. At the end of the quarter, the S&P 500 and Nasdaq 100 indexes were down 24% and 32%, respectively, for the year.
Bond investors faced similar challenges during the quarter. Interest rates across the yield curve have risen in response to the Fed’s rate hikes and their strong rhetoric against inflation. The rate increases sent shock waves through bond and equity markets simultaneously, creating turbulence for balanced investors, who were expecting more ballast from their bond portfolio against the turbulence of the equity markets. The US 10-year treasury bond yield briefly surpassed 4% before closing the quarter at 3.83%. The drastic increase in rates will undoubtedly affect the housing market, consumers, and the overall economy in the quarters ahead.
The rise of US interest rates has also led to a substantial strengthening of the dollar, which jolted international markets as many foreign currencies hit multi-decade lows versus the dollar. This has, in turn, forced many foreign central banks to raise their rates to maintain their own currency’s strength. The Bank of England (BOE) and European Central Bank (ECB) have been forced to do this at a time when their economies face additional inflationary challenges with the annexation of Ukrainian territory by Russia and the stoppage of the Nord Stream Pipeline, the main supply of natural gas from Russia to Europe. This will be a tremendous obstacle to their fight against inflation going forward and has put the European economy in a very precarious place.
At the end of the quarter, US equity markets were officially in the 269th day of a bear market. From a historical standpoint, this is now approaching the average number of days for a bear market when reviewing the past 26 bear markets since 1928. From a long-term perspective, investors may take solace in that most of the downward repricing may be in the rearview mirror. Inflation and the Fed’s policy response continue to be the key risks that markets will need to overcome in the quarters ahead for them to transition back to bull markets.
However, the war in Ukraine and the Mid-Term Elections could create additional uncertainties. Nevertheless, volatility is expected to remain elevated as the markets sort out these issues.
INFLATION & THE FED
This year, we have experienced the fastest rise in inflation since the 1980s. Despite the Federal Reserve’s efforts to slow down this runaway train, inflation is still strong.
At the September FOMC meeting, Fed Chair Jerome Powell expressed that, “Our expectation has been we would begin to see inflation come down, largely because of supply-side healing. We haven’t. We have seen some supply side healing, but inflation has not really come down.”
In their continued efforts to combat public enemy #1, the Fed increased their interest rates again by 75 basis points (or 0.75%) for a target range of 3.0% to 3.25%. This marked the third time the Fed has raised rates by 75 basis points and the fifth time they have increased rates in 2022.
Inflation is a real concern for Americans because it eats into our purchasing power and lifestyle. Anyone who drives, eats, turns on the lights, swipes a credit card, or has living accommodations, is experiencing the effects of inflation. Most Americans see the pressure in four major areas: the grocery store, the gas pump, their electricity bill, and housing costs, whether they are renting or buying.
It’s very possible that interest rates will remain elevated in comparison to the low-rate environment experienced over the past few years, and they could be here for some years to come. Since the 2010’s, Americans have been enjoying historically low-interest rates. Now, interest rates are front and center as the Fed stands by its commitment to combat inflation.
GLOBAL ECONOMY & MARKETS
Global manufacturing and services activity weakened during the quarter, indicating a slowdown in economic growth. The global ISM Purchasing Managers Index indicated this trend, ending the quarter at a contractionary reading slightly below 50.
The slowdown was mostly attributed to European economies. However, U.S. manufacturing declined to levels in line with other internationally developed countries leaving the services side of the economy to pick up the slack.
Inflation continued to be the most critical issue for capital markets in Q3, as evidenced by the higher-than-expected US August Consumer Price Index print of 8.3%. Although economists expected a figure near the 8% mark, this was at the top end of their range. This, of course, added to the concerns that inflation may continue to run hotter than anticipated in the months ahead. The Eurozone rate of inflation for August was significantly higher at 9.1%.
Energy inflation continues to be the most significant contributor to inflation pressures for the continent, given their dependency on Russian oil and the challenge of procuring supplies for the impending winter demand. The persistently high inflation, coupled with higher interest rates and negative growth, has many economists believing that Europe may have already tipped into a recession.
Borrowing rates have increased sharply over the past year, with conventional mortgage rates doubling. Demand in the housing sector had already begun to cool during the quarter as both home buyers and builders reassessed their plans to buy or sell residential properties. Home prices have already started to fall in lockstep with higher borrowing costs.
The inflation picture for the US has undoubtedly contributed to the weakening of many other leading economic indicators. “The Conference Board Leading Economic Index (LEI) for the US declined for a fifth consecutive month in July, suggesting recession risks are rising in the near term,” said Ataman Ozyildirim, Senior Director of Economics, The Conference Board.“Consumer pessimism and equity market volatility, as well as slowing labor markets, housing construction, and manufacturing new orders, suggest that economic weakness may intensify and spread more broadly throughout the US economy. The Conference Board projects the US economy will not expand in the third quarter and could tip into a short but mild recession by the end of the year or early 2023.”
Despite staging a mid-quarter recovery, every major US index sold off toward the end of the quarter on inflation worries ending the period nominally lower than where they started. The decline following the Jackson Hole Conference accelerated after the Fed’s September meeting causing US indexes to lose between 9% and 10% for the month alone. Both the S&P 500 and Nasdaq 100 posted mid-single-digit losses to close the quarter.
Both value and growth stocks delivered comparable results for the quarter, leaving investors with very few places to hide from volatility. Of the eleven sectors that comprise the S&P 500, only consumer discretionary and energy stocks managed to produce slightly positive gains. However, every sector participated in the sharp selloff that ensued in September. Equity valuations have now reached compelling levels, with the S&P 500’s price-to-earnings multiple trading at an 11% discount to the 25-year average. The uncertainty surrounding Q3 earnings and the effect that inflation may have on profit margin declines is what has been weighing on investor sentiment. Most equity analysts forecast a 5% decline in earnings for the quarter from the prior year, and market prices may have already discounted this expectation.
Equity analysts conveyed a similar sentiment before Q2 earnings were reported but were surprised by the earnings and margin resiliency that most corporations exhibited during that reporting season. With Q3 earnings season coming into full swing, it will be critical to see the impact inflation will have on profitability. A disappointment to the already lower revised estimates could very well stoke additional volatility. However, if earnings and forward guidance fall in line with expectations, it could be a sign that earnings may be bottoming.
Treasury bond yields rose sharply across the maturity curve in response to the Fed’s rate hike decision, with short-term rates still at higher levels than intermediate and long-term rates. The U.S. 10-year treasury briefly rose above the 4% mark before settling at 3.83%, whereas 1-year to 5-year maturities ended the quarter marginally above 4%.
The reason short-term rates have risen above long-term rates has much to do with the near-term inflation expectations of the market and the direct influence the Fed has on these rates. Intermediate and long-term rates have lagged behind those of shorter maturities due to the belief that growth may be slowing and that the long-term run rate of inflation will come down in the future.
The US bond market posted similar returns to US equities for the quarter in light of rising rates. This offered balanced investors little diversification benefit than what would normally be expected in a volatile equity market. Nevertheless, the Bloomberg US Aggregate Bond Index yield, a broad bond market index, ended the quarter at an attractive level of 4.75%. This is a yield not enjoyed by investors in well over a decade.
It has certainly been a difficult year for the bond market, given the inflationary environment and the Fed’s policy response. But when investing in bonds, it is important to recognize that nearly 80% of the return that one receives is from the income and reinvestment of that income. Bond investors may experience additional bumps in the road ahead as the Fed continues to tackle inflation. However, with yields well above the Fed’s long-term inflation target of 2% - 2.5%, they are getting well compensated for their patience.
Since 1928, we have experienced 26 bear markets, including the one we are currently in. Bear markets are categorized by a 20% or greater decline in the price of equities. The average time for a typical bear market has been 289 days, with the price decline approaching 30%.
Many critics have compared the Fed’s current rate hike cycle to the rate hike cycle of 1981 under Paul Volcker, where equities declined by roughly 27%. Given where equities closed for the recent quarter as well as the duration of the current bear market, one could assume that markets have already endured much of the downside.
The pace of inflation and the Fed’s future policy response will continue to be key market risks for the remainder of the year. If inflation persists, this could create more volatility for equities and bonds in the month ahead. However, if inflation subsides, the market will begin to discount a less hawkish Fed, which could lead to a recovery for both asset classes.
The upcoming Mid-term Elections could also be another catalyst for volatility in the near term. However, historically, a switch in Senate and House party majorities has generally been positive for markets. Additionally, should the November Elections result in congressional gridlock, inflation expectations could decline further as it would be exceedingly difficult to pass future spending bills.
These are challenging times for investors, and we want you to be comfortable knowing that we are staying apprised of the issues that may affect your situation. Having a proactive approach to your financial goals and a well-defined investment discipline is important for your long-term success. Maintaining that discipline in the wake of financial media influences is critical. To quote the “Father of Value Investing”, Benjamin Graham, “The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavior discipline that are likely to get you where you want to go.”
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