Market Commentary - Q3 2022 - Stocks and bonds down for third straight quarter
Key Takeaways:
- Stocks and bonds fall in tandem
- Core inflation continues to rise
- Wage inflation remains a major concern
- Labor market may be cooling, however holiday season hiring could keep it tight
- Fed continues to aggressively raise rates
- Struggle to find safety - 60/40 portfolio continues to underperform
- Strong USD poses global economic risks
- Is an earnings recession priced in?
- Major holiday period coming up for retail
Stocks and bonds down for third straight quarter
The sell-off across stocks and bonds deepened in the third quarter as hope faded that monetary tightening would soon ease, sending bond yields soaring (bond prices lower) and leaving US stocks on track for their worst year since the 2008 financial crisis.
All three of the major US equity indexes closed the third quarter at their lows for the year and are all in bear markets, down over 20% YTD.
The intensifying declines alarmed investors who entered the quarter enjoying a summer rally that more than halved the S&P 500’s 2022 losses before fizzling. There have been very few asset classes for investors to hide to provide downside protection or a hedge against equities as prices across the board have been under pressure.
Growing certainty that the Federal Reserve would persist in raising interest rates to fight inflation despite the risk of economic pain rattled markets. The yield on the 10-year US Treasury note climbed above 4% for the first time in more than a decade, while the dollar strengthened to a decades long high against other currencies.
Fed Vice Chairwoman Lael Brainard said on Friday that while the central bank was monitoring financial tremors that could result from its rate-rising campaign, it wasn’t going to halt it prematurely. Underscoring the challenge facing the Fed and other central banks, data releases Friday in the US and Europe showed no signs of price increases abating.
Core inflation continues to rise
While headline inflation seems to have peaked as energy prices come down, core inflation has shown no sign of slowing as the stickier parts of inflation continue to see pricing pressure. The so-called core PCE index, which excludes volatile food and energy prices, increased 4.9% in August from a year ago, up from a revised 4.7% in the year through July. On a monthly basis, core prices rose a seasonally adjusted 0.6%, accelerating sharply from July, when price growth remained flat.
Accelerating core costs show that high inflation is spreading increasingly to the services side of the economy, where prices tend to be sticky, meaning that once they rise, they are usually slow to reverse. Policy makers watch core inflation closely as a predictor of future inflation.
The Fed faces the challenge of tightening monetary policy to ease demand enough to curb inflation without triggering a deeper economic downturn.
Wage inflation remains a major concern
The most powerful threat to the economy and markets is an unsustainable trend higher in wages. The wage-price spiral is a concept describing the relationship between price levels and wages.
Congress has added $2.8 trillion of additional stimulus (about 13% of GDP) in the past 18 months alone, and that frenetic big-government spending preceded a record crash in real income. Real incomes are down 4.3% compared to last year. That’s much worse than the 1.6% decline in the mid-1970s. The drop in real incomes has boosted unions. A recent Gallup poll revealed that 71% of Americans approve of unions, the highest rate since 1965.
Wage increases tend to lag moves in broad inflation measures like CPI. Recent supply shocks and record stimulus drove prices higher, and workers have demanded wage increases in response to higher prices. As the call for higher wages broadens across the economy, the risk is that wage gains become ingrained, putting more upward pressure on the price level.
The job market also remains incredibly tight, with nearly 7 jobs vacant for every 100 workers, more than double the pre-Covid average. Employees that switch jobs continue to raise their incomes vs. those who stay put. The spread is the widest it’s been on record and reflects the continued urgency to fill vacant positions.
Labor market may be cooling, however holiday season hiring could keep it tight
US employers pulled back sharply on job openings, and layoffs rose in August, adding to signs the labor market cooled at the end of the summer.
The Labor Department said that total job openings fell 10% in August to a seasonally adjusted 10.1 million from 11.2 million the month before. The 1.1 million drop in openings is the largest decline since the early months of the Covid-19 pandemic, and job openings are at their lowest level in a year.
Openings dropped the most in healthcare, retail and other services industries. The decline in openings coincided with an August easing of job growth.
A tight labor market is one of the leading factors to the Fed staying aggressive with their interest rate hikes so this data will be very important to keep an eye on in the coming months.
Fed continues to aggressively raise rates
In response to accelerating core inflation, Fed officials raised the benchmark federal-funds rate by 0.75 points, the fifth consecutive rise since March. The move brought the rate to a range between 3% and 3.25%, a level last reached in early 2008.
Fed Chairman Jerome Powell said at a news conference last week that the central bank would continue to lift interest rates and keep them high until it is certain that inflation has been quelled.
“We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t,” said Mr. Powell.
Fed officials projected that rate rises will continue into 2023, with most expecting the fed-funds rate to rest around 4.6% by the end of next year. That was up from 3.8% in their projections this past June. While there is debate as far as how high the federal-funds rate will go, one thing is for certain, interest rates will remain elevated for the foreseeable future.
Struggle to find safety - 60/40 portfolio continues to underperform
The market is finally getting the message that the era of cheap money is over. The worst bond rout in decades shows few signs of abating, threatening further pain for both investors and borrowers.
One particularly disorienting twist of 2022: Bonds have fallen alongside stocks, giving investors few places to hide.
The S&P 500 has fallen 24% this year, with all three major U.S. stock indexes heading toward their worst annual performances since 2008. Bonds haven’t provided a ballast to portfolios—the Bloomberg U.S. Aggregate bond index is on pace for its worst year on record going back to 1976, down over 15%.
“In 50 years we haven’t seen debt and equity markets fall this much in unison,” said Rick Rieder, chief investment officer of global fixed income and head of the global allocation team at BlackRock Inc. “I’ve never spoken with clients so much in my life—everyone wants to know when this is going to be over.”
The 60/40 model, in which investors put 60% of their money in stocks and 40% in bonds, has faltered because Treasury bonds haven’t risen the way they classically do when stocks fall. In fact rising yields have sent the value of Treasury bonds lower.
Traditional hedges haven’t fared much better. Gold, historically seen as a haven against inflation, is down 8.8% in 2022, sparking three consecutive months of outflows from precious metals funds. Part of those declines are due to the surging dollar and rates. Gold does not pay any dividends or interest, so if an investor can hold a government bond paying an attractive interest rate, then gold prices typically fall.
Monetary tightening by the Fed has sent yields surging, hurting prices and eliminating the presumed hedge that bonds offer against stocks. The central bank has also signaled it will continue to raise rates until rampant inflation nears historic norms.
“We bought a tremendous amount of one-year Treasury bonds at 4%, you’re getting paid to hold cash,” said Mr. Rieder. “We love Triple-A-rated credit assets like mortgage-backed securities and collateralized loan obligations that mature in one to two years, which are offering yields between 5%-6%. Then there’s high-yield bonds offering 8%.”
“This is nirvana for a fixed-income investor,” he added.
Investors have parked nearly $13 billion in exchange-traded funds holding Treasury bonds that mature in one to three years. The iShares 1-3 Year Treasury Bond ETF, the largest such fund, shows a 3.7% expected return over the next year based on a calculation of its past 30-days of returns, as of Wednesday.
Strong USD poses global economic risks
The strong dollar is now one of Wall Street’s main concerns.
On Main Street, a rising dollar boosts Americans’ relative purchasing power by making imports cheaper. But the dollar is also at the center of world financial markets, and a stronger U.S. currency can have unforeseen consequences.
Some risks of a strong USD are: poor returns from emerging markets, decreasing corporate earnings, and currency intervention from international central banks.
Buy the dip trade is failing
During the era of easy monetary policy, investors blindly bought dips in equity markets as they dared not fight the Fed. As mentioned above, the era of cheap money is over and investors are again not fighting the Fed, however in the opposite direction. Buying the dip has failed tremendously in 2022. In fact, it is the worst year for buying the dip since the 1930s.
Instead of rebounding after a sell-off, stocks have continued to fall, burning investors who stepped in to buy the dip. The S&P 500 has dropped 1.2% on average this year in the week after a one-day loss of at least 1%, according to Dow Jones Market Data. That is the biggest such decline since 1931.
The extended downturn is putting a dent in the popular buy-the-dip trade, a strategy in which many investors found great success after the last financial crisis and particularly during the lightning-fast pandemic recovery.
Is an earnings recession priced in?
It takes time for the full effects of higher interest rates to filter through the economy, leaving investors wondering how the Fed’s sequence of rate increases that began in March will eventually affect the behavior of businesses and consumers.
Given the pace of monetary tightening, many suspect that an economic slowdown will dent corporate earnings, eroding the attractiveness of company shares. While stocks look considerably cheaper than they did to start the year, the broad market’s valuations haven’t fallen far enough that traders are rushing in to buy.
Markets have responded harshly to signs that a weakening economy could cut into profits. FedEx shares slumped 21% in mid-September in their biggest one-day drop on record after the delivery company warned of a sharp drop in package deliveries. The stock was one of the S&P 500’s worst performers in the third quarter.
Also, the strong USD poses a threat to international corporate earnings. US corporations involved in international business have cut earnings guidance since June, citing the dollar’s gains. Microsoft, Deere, FedEx, and Nike all warned that a stronger dollar would strain future profits.
That has translated into stocks, where companies with large sources of foreign revenue took a hit earlier this year—including Apple Inc., Google parent Alphabet Inc., and chip maker Nvidia Corp. While the market has rebounded since then, more companies are sounding the alarm, which could mean extra pain ahead for stock investors.
Professional investors broadly are shying away from risk. Bank of America’s September global fund manager survey found that average cash balances jumped to the highest level since October 2001, in the aftermath of the 9/11 terrorist attacks.
Individual investors are feeling particularly glum. Bearish sentiment, or expectations that stock prices will fall over the next six months, rose to its highest level since March 2009 in a recent poll from the American Association of Individual Investors. This could be seen as a contrarian indicator and a potential buy signal, however the risks of inflation and continued rate hikes are keeping investors on the sidelines.
The market is pricing sub-3% CPI by next year but historically, market-based expectations have typically undershot inflation by 70bps. CPI could still be around 4% next summer if the historical pattern repeats itself.
In our view, the missing link is rising recession risks. We saw premature bullishness over the summer with “meme” stocks up 40% from lows and US Treasury yields dropping sharply. US housing supply is the highest it’s been since 2009, foreshadowing serious economic pain, e.g. 8-9% unemployment by the spring of 2024.
Major holiday period coming up for retail
U.S. consumers are digging deeper into their wallets to cover rising costs of essentials such as rent and utilities as inflation spreads, a government spending report for August showed.
Household spending rose by a solid 0.4% in August after dropping a revised 0.2% in July, the Commerce Department said Friday. The August increase was just 0.1% after accounting for inflation. The higher spending came amid signs that inflation, already close to a four-decade high, has become increasingly entrenched in the U.S. economy despite the Federal Reserve’s aggressive moves to tighten monetary policy.
The upcoming holiday seasons will be a major test for consumer spending and give us terrific insight on how inflation and rising interest rates are affecting consumers buying habits, give us insights on just how strong their balance sheets actually are, and their confidence levels for 2023.
Outlook
Business Cycle
As a continuation to our research piece and investing thesis of “Seeking opportunities in business cycles”, we believe that the US economy is now in the late stage to recession stage of the business cycle.
It has been our view for the majority of 2022 that US equity markets will need to wipe out their COVID gains that were largely attributed to an influx of money supply created by the Federal Reserve.
Cash for now, Quality for later, Value stocks forever
With these risks in mind, our near-term preference is cash > credit > equities. Within equities, we prefer high-quality stocks that generate consistent free cash flow.
While we have favored these trades for much of 2022, it isn’t too late: valuations and entry points remain attractive.
Short-term: cash rebounds from generational lows
Cash returns are rebounding as the era of low rates and QE starts to reverse. Investors at or near retirement should be cautious and look to build cash/safe-haven reserves by holding short-term cash vehicles such as short term treasuries.. We recommend investors at or near retirement hold a minimum of 2 years of expenses in cash and a maximum of 5 years of expenses in cash. Medium to long-term investors should hold 12 months to 24 months of expenses in cash (elevated from a typical 6 month emergency fund).
We expect positive returns for the foreseeable future with Fed funds expected to touch 4.25% by early next year.
Below are the current yields for various cash vehicles. Short-term rates are competitive, if not yielding more than medium-term rates, meaning investors are finally being paid a meaningful interest rate to hold cash for the short-term.
Medium-term: Yield & Quality
We continue to favor large-cap equities with quality balance sheets, with strong cash flow that pay dividends.
As interest rates continue to rise and inflation persists, we are still overweight US equities as they provide strong inflation protection overtime.
Long-term: Value and core equity holdings
Finally, only if sufficient cash reserves have been accumulated, consider using the sell-off to build longer-term positions. Equity valuations have been the most attractive that we have seen in years. That being said, investors should proceed with caution when buying equities and do so with a dollar cost averaging approach as we are not ready to call a bottom yet.
We believe areas most at risk for further decline are cryptocurrencies, auto manufacturers, software companies, consumer discretionary, and the overall tech sector excluding meg-cap tech (although they may get caught up in further selling of the Nasdaq). We strongly favor quality value companies over growth in 2022 and beyond.
Investors shouldn’t react emotionally or aggressively when rebalancing portfolios to reduce risk exposure. Aggressive market-timing attempts, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. It’s often better to stay invested to avoid missing out on the upswing.
With so many assets trading at steep discounts to their earlier prices, this could seem like a time to buy. But a murky view into the path ahead is keeping many investors from making big bets.
