After the worst first-half performance for markets in almost 50 years, the third quarter of 2022 got off to a strong start driven by a “peak inflation” and “peak Fed hawkishness” narrative. Stocks and bonds rallied in tandem throughout July and into August, boosted by second quarter earnings that were “not as bad as feared” and the perceived shift in the inflation and interest rate outlook. Those optimistic days now seem like a distant memory as markets closed the quarter making new lows and plunging decisively back into bear market territory. At the August 26th Jackson Hole symposium, Fed Chair Powell’s hawkish messaging was a powerful rebuttal of the market’s previously dovish interpretation of Fed intentions. The U.S. and global capital markets have traded lower ever since.
Almost all major asset classes added to their losses for the quarter and remained down for the year. Commodities were the one exception during the third quarter. The energy sector, up 30% year-to-date, is the only equity sector with positive performance in 2022. We note, however, that growing concern about a synchronized global economic slowdown began to weigh on the broad commodity complex toward the end of the quarter. Within equities, the Technology and Consumer Discretionary sectors, which are highly geared to strong economic growth, are both down approximately 30% year-to-date.
For the quarter, the large-cap S&P 500 fell 4.9%, the blue-chip Dow Jones Industrial Average was lower by 6.2%, the tech-laden NASDAQ dropped 3.9%, and the small-cap Russell 2000 fell 1.8%. Equity sector performance was broadly weak. The best-performing sectors included Consumer Discretionary (+4.4%) and Energy (+2.2%). The worst-performing sectors included Communication Services (-12.7%), Real Estate (-11%), and Materials (-7.1%).
As previously discussed, the benign backdrop of a relatively calm geopolitical climate, low interest rates, and below-average inflation buoyed stocks and bonds over the past ten years. However, market conditions have significantly changed, with inflation at a 40-year high. The general expectation is that the Fed will continue raising interest rates at the fastest pace since 1994, with a backdrop of dramatically higher geopolitical risks due to Russia’s invasion of Ukraine and escalating political, economic, and military tension with China.
Market skittishness is exemplified by the reaction to July inflation data which showed an 8.5% year-on-year rise (and flat month-on-month reading) in the key Consumer Price Index (CPI). Despite this elevated level, the market reacted favorably as the July data represented a material decline from June’s 9.1% year-over-year and 1.3% month-over-month readings. This fueled investors preferred “peak inflation” narrative, which would see an earlier than expected end to interest rate hikes. Markets rallied strongly on this perception.
The rally quickly reversed in the wake of very hawkish comments from Fed Chairman Powell, who cautioned “against prematurely loosening policy” and warned of “some pain” coming to households and businesses.” If this was not enough to weaken investor enthusiasm, the higher-than-expected August CPI report (8.3% y/y and 0.1% m/m) sealed the deal, prompting the worst single-day declines in major stock indexes since June 2020. The prevailing market narrative quickly returned to a “higher for longer” rate environment, and market declines accelerated into the end of the quarter.
The bond market exhibited similar – if not more extreme – volatility as markets digested the rapid move from “hawkish” to “dovish” sentiment and then back again. Two-year Treasury yields initially fell below 3% in early August due to the more dovish narrative but ended the quarter at 4.25% after hitting a high of 4.35% on September 26th. Likewise, the Ten-year Treasury yield approached 2.5% in early August but ended the quarter at 3.81% after briefly touching 4% on September 27th. The sharp bond market adjustment came in the wake of renewed “hawkish” Fed messaging in the runup to its September rate decision that saw a 75 bps increase to a target rate of 3.25%.
The rate increase was accompanied by a gloomier view of 2023 economic growth from the Fed’s Open Markets Committee (FOMC), with a notable GDP growth downgrade from 1.7% in the median June projection to 1.2%. The median projection sees unemployment rising 70 bps (compared to a 50 bps increase forecast in June) to 4.4% in 2023. Fed officials view higher unemployment as a necessary precondition for reducing inflation. Further, the FOMC interest rate dot plot is now significantly more hawkish, with the median December interest rate projection at 4.25% - 4.50%, implying another 75bps and 50 bps increase in November and December, respectively. The median projection for 2023 is now 4.50% - 4.75% in 2023, with no cuts forecast.
Volatility was not confined to equity and bond markets, and Q3 saw continued – and worsening – dislocation in global currency markets. The dollar continued its rapid appreciation on the back of higher U.S. interest rates despite the forecast economic slowdown, which compares favorably with the quickly deteriorating growth outlook elsewhere, particularly in the Eurozone, China, and the U.K. The Bloomberg Dollar Index rose an additional 6.1% in Q3 and is now up 13.9% YTD.
Central banks have taken widely varying actions to address the two critical drivers of dollar strength. These range from the Bank of Japan’s (BoJ) first foreign exchange market intervention since 1998 to indirect measures from the People’s Bank of China (PBOC) to stem the depreciation of their respective currencies against the dollar. The impact of the interventions was short-lived; both the yen and yuan are again flirting with their lowest levels of the year.
The European Central Bank (ECB) followed a more orthodox monetary policy with its 75 bps rate hike in early September. While this was the largest rate hike in ECB history, it only moved the benchmark rate to 1.25% after its July hike got rates above zero for the first time since 2016. More rate hikes are expected as Eurozone inflation was 9.1% in August, and the economic growth outlook is far worse than in the U.S.
The outlook for the U.S. economy remains murky. The first half of 2022’s economic contraction reflects deflating forces of inflation on nominal growth, without the typical labor and consumption contraction, though risks to these sources of growth are rising. Despite these looming risks, estimates for 2023 and 2024 GDP growth remain positive, albeit at lower levels than previously forecast. However, given the lagged impact of rate hikes and the size of additional hikes projected, the most significant impact of the Fed’s rate hikes will only be felt in 2023, thereby increasing the probability of a recession or near-zero economic growth. Any signs that both inflation and/or inflation expectations are moderating would be a strong market catalyst, especially if those signals come before too much economic damage is done.
With elevated volatility in all major asset classes likely to continue in the fourth quarter and into 2023, a cautious stance is appropriate. We are proactively rebalancing and flexibly repositioning portfolios as we face the clear headwinds of economic uncertainty, including the prospects for a U.S. and global recession and the accompanying government and central bank policy responses.
Within both fixed income and equities, that means an even sharper focus on balance sheet strength, allowing companies to weather a downturn and grow their businesses when financially weaker rivals stumble. In fixed income allocations, this translates into an emphasis on high-quality investment grade fixed income securities. At the same time, we remain ready to exploit mispricings in the high-yield market as they arise opportunistically. Cognizant of client cash flow needs, the overall fixed income portfolio remains in shorter-duration securities. This may evolve over the coming quarters as the U.S. interest rate environment becomes more apparent.
Our global equity portfolio remains overweight large-cap domestic stocks relative to international. We see late-cycle dynamics in the market favoring large-cap and high-quality style factors, and as a result, we are underweight small-caps. Within our large-cap stock allocation, we are positioned with a defensive and value bias and significantly underweight the Information Technology and Consumer Discretionary sectors which are the most sensitive to continued economic weakness. We are similarly focused on companies with strong cash flow and balance sheets and de-emphasizing companies with weak financials and no or limited near-term earnings. The latter face materially higher financing costs and significantly lower valuations of their hoped for future cashflows and earnings due to higher discount rates. We prefer companies with strong pricing power or expense pass-throughs and lower labor intensity to mitigate the risks of a persistent inflationary environment. One area of opportunity that we recently moved more favorably towards is energy infrastructure, where demand remains robust and income distributions are attractive.
Under challenging markets such as we are currently experiencing, it is crucial for investors to maintain perspective and put current events in context. This year’s dislocation in the bond market ranks among the worst in U.S. history. The year-to-date drawdown in U.S. Treasuries is double that experienced during the 2007-2009 global financial crisis. In contrast, equity market declines have been less severe than in the 2008-2009 Great Financial Crisis and the 2000-2001 “dot.com meltdown,” though it doesn’t make it less painful for investors.
However, in uncertain times and volatile markets, investors should keep in mind the empirically proven benefits of remaining invested in U.S. financial assets. Despite the broad year-to-date losses, it is important to note that most asset classes are still higher than pre-pandemic levels, and in the last 3, 5, and 10 years, stocks have returned over 8% on average, including the dismal performance so far in 2022.
Investors with a medium- to long-term investment horizon should stick to a disciplined investment process, asset class and security-level diversification, and prudent risk controls at precisely those moments when it is hardest to do so. The best-suited asset allocation mix aligns with the goals, objectives, and risk tolerances to weather episodic periods of volatility. Investors can help manage risk, in coordination with their advisor, by choosing a mix of stocks, bonds, and cash based on these goals and objectives. If risk tolerances have changed since the last assessment, we can schedule a new asset allocation review. In closing, history and research have demonstrated that investors who commit to a long-term asset allocation policy that embraces diversification and risk controls are likely better equipped to take advantage of the market’s volatility to reach their long-term investment goals.
Written By:
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Jason Nerio Vice President, Director of Investment Research and Strategy First American Trust |
Jason Nerio is the Director of Investment Research and Strategy at First American Trust. Mr. Nerio has more than 20 years of investment research experience. He is responsible for formulating investment strategy and serves as a leading member of the investment committee which monitors and manages the firm’s allocation strategies for over $1 billion in client assets.
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Scott Dudgeon, CFA Director, Equity Research First American Trust |
Scott Dudgeon is the Director of Equity Research at First American Trust. Mr. Dudgeon is a Chartered Financial Analyst (CFA) and has more than 25 years of investment research experience. He also serves as a leading member of the investment committee and has a proven track record for outperforming the markets for our clients. He has been with The First American Family of Companies for 16 years.
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Bruce Schoenfeld, CAIA Principal Investment Analyst First American Trust |
Bruce Schoenfeld is the Principal Investment Analyst responsible for investment research coverage of various asset classes and equity industry sectors at First American Trust. Mr. Schoenfeld has more than 20 years of experience as an equity analyst and portfolio manager.
The following article is for informational purposes only and is not and may not be construed as legal and/or investment advice. Investments contain risks, no third-party entity may rely upon anything contained herein when making legal and/or investment determinations regarding its practices, and such third party should consult with an attorney and/or an investment professional prior to embarking upon any specific course of action.
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