In our 2nd Quarter Market Commentary, we discussed our expectations that the market turmoil would continue in the 3rd Quarter due to Fed policy uncertainty, inflation expectations, the outlook for future corporate earnings, and the continuing war in Ukraine. The 3rd Quarter began on a somewhat optimistic note. Inflation, especially gasoline prices, appeared to have peaked and there was hope that inflation would moderate quickly, appeasing the Fed and avoiding a recession. Earnings for the 2nd Quarter were lower than the previous year but still strong, making the case for a soft landing and providing hope the market might look through the current economic slowdown. The war in Ukraine continued but had not spread to neighboring countries. From the perspective of the market, more attention was focused on the economic fallout of the war, especially with regards to energy prices, and the effect on overall inflation and slower economic growth in the eurozone, and less attention was paid to the growing humanitarian crisis in Ukraine. The U.S. markets set aside international risks and instead focused on more optimistic domestic news from July through mid-August creating a short-lived bear market rally for equity and bond markets.
Then came Fed chairman Jerome Powell’s speech at the annual Jackson Hole conference. He used it to place a clear emphasis on reducing inflation to 2%, even at the cost of a recession. The clarity of this message brought the summer market rally to a swift halt. Shortly thereafter, the August Consumer Price Index (CPI) report was more elevated than expected. The realization that inflation is still in the windshield and not the rear-view mirror, coupled with Chairman Powell’s crystal-clear determination, effectively ended what has been known for years as the “Fed Put.” The “Fed Put” is a widely held belief that the Fed will step in to buoy the markets with monetary accommodation. The equity market’s response to Chairman Powell’s comments was a complete reversal. By the end of the 3rd Quarter, all the major stock market indexes reached levels not seen since 2020, setting new closing lows for the Dow Jones Industrial Average, S&P 500, and Nasdaq indexes on September 30th. For stock investors, the 3rd Quarter probably felt like a broken record stuck on a terrible song.
Bond investors faced similar challenges in the 3rd Quarter. Interest rates continued rising across the yield curve as the Fed raised the Fed Funds rate 0.75% in both July and September and continued their strong rhetoric against inflation. The rate increases sent shock waves through the bond and equity markets at the same time, roiling portfolios that invest in both stocks and bonds. The ten-year Treasury bond yield briefly went over 4% in overnight trading before ending the 3rd Quarter with a yield of 3.83%. The effects of the dramatic increases in rates will affect housing, the consumer, and the U.S. economy broadly in the 4th Quarter and into 2023. Not only are U.S. interest rates rising domestically, but also relative to the rest of the world. This resulted in a strengthening dollar, which jolted non-U.S. markets as many foreign currencies hit multi-decade lows vs. the dollar. Europe faces additional challenges with the annexation of Ukrainian territory by Russia and the stoppage of the Nord Stream Pipeline, the primary supply of natural gas from Russia to Europe. This will prove a challenge to Europe’s fight against inflation in the 4th Quarter.
All three major stock indices posted negative returns for the third straight quarter bringing year-to-date returns for the Dow Jones Industrial average to -19.72%, the S&P 500 to -23.87%, and the NASDAQ to -32.00%. International and Emerging stock market performance was much worse than U.S. stock market performance in the 3rd Quarter bringing their year-to-date performance to between -26% to -28%. Growth-oriented stocks actually outperformed value-oriented stocks in the 3rd Quarter breaking a trend that started at the beginning of 2022, however, whether growth or value, large, small, or mid-capitalization, all stock indexes were negative in the 3rd Quarter. The best-performing sectors were Consumer Discretionary and Energy, while Materials and Technology were the worst performers. Bonds once again performed negatively in the 3rd Quarter as the Fed continued to raise the federal funds rate with expectations for additional rate increases through the end of 2022. The yield curve remains in a steep and sustained inversion, with short-term yields higher than longer-term yields. The gap has widened between short maturities, which are influenced by Fed policy, and longer maturities, which are more reflective of the future economic outlook. The yield curve has a strong history of predictive accuracy regarding future economic growth and right now, it is strongly indicating a recession.
Many market pundits have said the best cure for rising prices is rising prices. The logic is that, if left alone long enough, rising prices will eventually hurt consumers to the extent that they pull back on purchases, reducing demand and rebalancing the system. While that may be true, it would be a brave central banker indeed who chose to try that particular experiment in the current environment. Even if this laissez-faire approach did work, “eventually” would likely be an intolerably long time to wait. As a result, the Fed is not relying on high prices to self-correct. Instead, the Fed has embarked on a path of aggressive interest rate hikes not seen since the 1980s. Policymakers around the world are moving rates by 50, 75, or even 100 basis points at a time (0.50%-1.00%), scrambling to slow demand enough to bring inflation under control. We believe that process has more room yet to run and anticipate at least another 1.0%-1.5% of tightening from major central banks in the next few months. Once notable progress in reducing inflation is achieved, the Fed will begin to lighten up on the interest rate tightening cycle. Fed tightening works with a lagging effect and the big question is how much work they have left to do. It is important to remember the Fed is a reactive institution, and regardless of outlook, they likely will not let up until we see some improvement in month-over-month inflation data.
The tightening that has already taken place is beginning to have an impact—there are signs of an economic slowdown globally. Housing markets are cooling sharply as mortgage rates rise, and tighter financial conditions are dampening growth in general. In addition, money supply growth, the clear and present cause of widespread inflation, has dropped to zero from stratospheric levels of around 35% in late 2020 and early 2021. For context, money supply growth in the mid-single digits would be considered the normal ideal. However, we think there is more economic pain to come. It will simply not be possible for central banks to bring inflation under control without slowing growth and weakening labor markets. While in “normal” times, market participants might view a central bank raising rates into an economic recession as a policy mistake, in this environment we think it may be necessary to do just that. We expect a recession in both the eurozone and in the UK, with growth likely to be consistently negative for several quarters. In the U.S., we forecast growth to be at or near zero for several quarters: better certainly than in Europe, but not good in any absolute sense. And certainly not as good as the U.S. economy experienced in 2020 or 2021. Whether that is officially determined to be a recession or not is a semantic question rather than a substantive one – the outlook is murky at best, no matter what words one wishes to use to describe it.
That said, it is important to put our expectations in context. While inflation is putting immense pressure on the global economy, we believe that this too shall pass. Central bankers are taking the appropriate steps to bring inflation down. While that process will be painful, we believe that it will eventually be successful. Even during what will be challenging months to come, there are reasons to expect that the coming downturn will be minor compared with past recessions. Household finances, buoyed by pandemic-era stimulus, are robust, corporate balance sheets are strong, and the global financial system does not seem particularly vulnerable to asset price bubbles. Instead of a sharp downturn, we expect a milder, grinding slowdown that persists for several quarters but does not cause the same economic and social dislocations as the last two recessions.
The post-great financial crisis market backdrop has shifted from one of low inflation, low-interest rates, and low stock market volatility to a new market backdrop with higher structural inflation, higher interest rates, and higher stock market volatility. This year has been historic for so many different reasons, especially for the losses suffered by the vast majority of bond investors. Not for our clients. We saw problems for bonds coming years ago and believed that 2020 was going to be the turning point for higher interest rates. Then COVID came and the distortions in interest rates just got worse pushing out by two years what we expected would be a difficult market environment for bonds. The distortions created by 13 years of near-zero interest rate policies, the massive amounts of COVID-related stimulus, both fiscal and monetary, coupled with the highest inflation in 40 years got us to where we are today. As investment advisers, our job is to maximize returns when we believe the current and expected future economic environment has a high probability to produce positive returns for investors. When the outlook in the short and medium term becomes more unclear our job must switch to capital preservation. This year has been about doing the best we can to preserve capital by actively reducing asset allocations to asset classes that we believe would underperform. In addition, we implemented investment strategies designed to profit in a rising interest rate environment. Some market pundits have said that the 60% stock/40% bond portfolio is dead because bonds have done so poorly in 2022. We totally disagree. What is true is passive, computer algorithm-managed portfolios, which have been so popular in the near-zero interest rate environment of the last 13 years, once again failed investors as it had during the financial crisis. Not since the 2008-2009 great financial crisis has the Wall Street legacy distribution system exposed investors to excessive losses in supposedly “balanced” portfolios due to nothing more than apathy in believing that a “do as little as possible” investment strategy is somehow in the client’s best interest.
This is not how we have managed portfolios for the last 33 years, and we never will. The future for a 60% stock/40% bond portfolio is actually brighter than it has been since before the financial crisis in 2008 because bond yields are the most attractive they have been in 15 years. However, before we get to that brighter future, the market for all risk assets, stocks, bonds, real estate, and commodities must go through a repricing process that reflects the new reality of higher interest rates, higher inflation, and slower worldwide economic growth. The process is ongoing, but if history is any guide, the bear market for stocks that began at the beginning of 2022 should be over by the summer of 2023. We believe stocks will continue to be buffeted by higher volatility until the Fed stops raising interest rates sometime in the 1st Quarter of 2023. In the near term, we expect our stock allocations to remain near the lowest they have been in the 33-year history of our firm through the end of 2022, and we expect to continue increasing our asset allocations to bonds as interest rates move higher.
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