This quarter, the Federal Reserve continued to actively combat high inflation with historic interest rate hikes, with two .75% hikes. The Fed remains steadfast in its fight against inflation and after the September meeting, where an additional 1.5% in hikes were projected, the S&P 500 and Barclays Aggregate Bond Index declined sharply and contributed to declines of 4.9% and 4.8%, respectively, this quarter. The bond market, measured by the Aggregate Bond Index, is on track to have its worst annual performance in 95 years. The Fed has clearly stated its intention for future hikes and the fixed-income market has adjusted with higher yields. Stock valuations have fallen sharply, and investor sentiment remains low. Stocks likely need a catalyst, such as falling inflation or a less aggressive Fed, to move higher.
The S&P 500 started the third quarter with a substantial rally, 9.2% in July after the Fed made comments that investors viewed as more accommodative. Surprisingly, robust corporate earnings and the possibility of peak inflation bolstered the equity markets, pushing markets higher through the first half of August. Investors anticipated the Federal Reserve would pivot toward a more accommodative policy. At the annual Jackson Hole summit, Chairman Powell reiterated that containing inflation was still their focus and stocks fell about 6% during the week of the announcement. In September, the Fed again raised the short-term rate by 75 basis points, contributing to the S&P 500’s decline of 9.2% in the month and dip into a bear market territory, finishing the quarter down 4.9% and 23.9% for the year.
Only two of the 11 sectors in the S&P 500, Consumer Discretionary and Energy, finished the third quarter in the black, buoyed by strong consumer spending and elevated oil prices. Communications Services once again was the worst performing sector as investors cycle out of the most interest rate sensitive areas of the market, which performed so well leading up to higher interest rates.
Surprisingly, growth stocks outperformed value stocks and small capitalization stocks outperformed large-cap stocks in the quarter. This divergence came mainly from the rally in July when investors anticipated a Fed shift toward fewer hikes. Even with the relative win, growth stocks are still having their worst year since 2008. Large-cap stocks, which receive a larger percentage of revenues from overseas sales, are facing a surging U.S. dollar which is hurting profits.
Like the domestic markets, international developed market stocks started the quarter off with a rally but faltered and finished the quarter down. Geopolitical issues weighed on foreign markets as electricity and energy prices surged across Europe as the war in Ukraine drags on. The Fed was among the first developed central banks to hike rates, which enticed foreign investors to purchase U.S. debt, causing the U.S. dollar to rally. In the quarter, the Euro fell 6.5% and the Pound plummeted 8.5% versus the dollar. In local currency terms, international stocks outperformed domestic stocks by over 1%, but the negative currency headwind resulted in a sharper decline. The MSCI EAFE Index, a proxy for developed international stocks, dropped 9.4% in the third quarter and 27.1% for the year.
Chinese lockdowns related to Covid, troubles in the housing market, and slowing economic growth caused the largest emerging market country to fall 22.5% in the third quarter. At nearly a third on the index, China’s weight brought the MSCI Emerging Markets Index down 11.6% for the quarter and 27.2% for the year. Chinese officials have taken measures to increase growth, but thus far the impact has been minimal. However, it wasn’t bad for all emerging market countries as both India and Brazil posted gains in the quarter.
The highest inflation in 40 years caused the Fed to raise rates with an urgency we haven’t seen since the early 1980s. Over the last quarter, the Bloomberg U.S. Aggregate Index fell 4.8% bringing it down 14.6% for the year; on track for the worst yearly return in 95 years.
The yield on the 10-Year U.S. Treasury increased another .85% during the quarter, ending at 3.83% after briefly crossing 4%. The two-year Treasury finished the quarter even higher, at 4.22%. Traditionally, longer-maturity bonds have higher yields than shorter-maturity bonds, but the current “inversion” is unique. While this does not guarantee an upcoming recession, an inversion in the yield curve has frequently pre-dated past recessions. It is worth noting that the historic drop in bond markets has led to a large rise in bond yields (bond yields and prices move in opposite directions), which presents higher returns for bond investors going forward.
The U.S. economic business cycle is showing maturing signs as inflation pressures have triggered tighter monetary policy. U.S. gross domestic product (GDP) preliminary print is -.6% for the second quarter, posting the second negative quarter in a row which has many asking, “are we in a recession?” The National Bureau of Economic Research (NBER), the arbiter of the definition of recession, has not called an end to our economic expansion as some of its indicators remain positive.
The U.S. unemployment rate has remained under 4% all year, registering 3.7% in August. The unemployment rate has steadily dropped following the massive uptick in the early stages of the pandemic. Most companies continue to search for workers and the number of open jobs remains extremely high. The resilience of the labor market in the face of economic slowing and high inflation has many thinking any downturn in the economy would be shallow.
The Fed started its rate increase cycle in March with a .25% hike and followed that with three .75% hikes over the last three meetings, taking the overnight rate to a range of 3% to 3.25%. The Fed has been noticeably clear they are not done and plan to continue hiking into 2023, with an estimated 1.5% in hikes remaining. The Fed was clear in their September meeting that moving inflation toward their target was of the utmost importance.
This year has been among the toughest in history for investors. Very rarely do stocks and bonds move down in tandem and rarer still to this extent. Multiple investor and consumer sentiment indicators are as low as they have been since 2008. Since the Great Financial Crisis in 2008, central banks around the world have been backstopping the global economy via some of the lowest interest rates in history. Starting this year, they have largely exited that role and focused on taming inflation. Consequently, assets have been repriced with the backdrop of higher inflation and interest rates.
However, there are some signs that stocks may be nearing a bottom. The median decline in the S&P 500 during the last ten recessions is 24%, which is where the S&P 500 ended the third quarter. The S&P 500 is trading at 15 times forward earnings, historically an attractive level and well below the 21 times level to start the year. However, domestic stocks will likely need a catalyst to break the downtrend and persuade investors to begin purchasing riskier assets in earnest. Within the U.S., until inflation shows a strong downward trend, the Fed pivots to a less aggressive stance, or corporate earnings prove more relevant than inflation, its unlikely stocks will stage a strong recovery. International equities are trading at attractive values relative to earnings and relative to U.S. markets. A conclusion to the war in Ukraine could help tame European energy prices and improve investor sentiment and earnings. Chinese stocks are trading at exceptionally low values, less than 10 times earnings and a softer Covid policy or higher vaccination rates could unlock notable upside potential. Bond yields are at levels we haven’t seen since 2008. For the first time in well over a decade, bond yields exceed inflation expectations. Although rising rates have reduced bond prices, going forward both interest and principal can be reinvested at much higher rates. Future bond return expectations have increased and given the Fed’s recent transparency it is likely that rates will not move much higher, and prices will stabilize.
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Darin Richards, CFA®
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Darin joined the Portland wealth management firm in 2004, bringing more than a decade of investment and financial consulting experience with him. As chief investment officer for Aldrich Wealth, Darin is responsible for developing, and implementing our investment philosophy and leading the investment committee. He works directly with some of our most complex and largest clients and also…
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