Highlights
- Alternating hopes and fears about the Fed’s intentions kept markets volatile.
- After a strong July rally, the S&P 500 lost 4.9% in the quarter, bringing its 2022 loss to 23.9%.
- The only equity sectors with positive quarterly returns were Energy and Consumer Discretionary.
- The Bloomberg Aggregate bond index returned -4.9% for the quarter and -10.4% year-to-date.
- Value stocks outperformed growth stocks by 9.5% in the quarter and 16.2% year-to-date.
- The rate of inflation remained high, with year-over-year CPI up 8.3% in August.
- The Federal Reserve has accepted that a recession may be needed in order to reduce inflation.
Equities
The third quarter witnessed a tug of war between investors who believed that peaking inflation would soon lead the Federal Reserve to pause and then reverse its rate hikes and those who took the Fed at its word that rates hikes would continue for the foreseeable future. Given the Federal Reserve’s history over the last decade as the equity market’s “put” (Bernanke, Yellen, Powell), it’s understandable that a large segment of investors might question the Fed’s commitment to fighting inflation in light of sharp market sell-offs and the looming threat of recession. The sceptics led the market higher through the first half of the quarter, with the S&P 500 returning 13.9% through August 16. However, as conviction grew that the Fed was serious, the S&P 500 fell 16.5% and ended with a return of -4.9% for the quarter and -23.9% for the first nine months of the year.
Small cap and large cap stocks were down a similar amount in the quarter, while small caps maintained their slightly better performance for the year. As in the second quarter, value stocks performed more poorly than growth stocks, although since the end of 2021, they have lost just over half as much as growth stocks.
Despite the drop in oil prices, Energy was one of only two sectors with a positive return during the third quarter, trailing only the Consumer Discretionary sector. The two worst performing sectors for the quarter were Communication Services and Real Estate. Energy remained far and away the best performing sector year-to-date, along with the defensive Utilities and Consumer Staples sectors. With losses greater than 30%, the worst performing sectors so far this year have been Communication Services (which includes two of the FANG stocks) and Information Technology.
As the Federal Reserve has increased interest rates, estimates of earnings (on an as reported basis) for the S&P 500 companies have begun to come down. Earnings in 2022 are now expected to decline a little over 5% compared to the prior year. However, with corporate profit margins at record highs and the effects of higher inflation on consumer spending and corporate costs just beginning to be seen, it seems likely that corporate earnings could weaken further. (The analyst consensus estimate is for earnings to grow about 7% over the next 12 months.) The P/E ratio based on 2022 expected S&P 500 earnings stood at 19.1 on September 30, down from 22.7 at the end of 2021.
Fixed Income
September’s Consumer Price Index report continued to show a strong, albeit slightly lower, rate of inflation, with prices up 8.3% in August over the prior year. While this was the lowest annual rate since April, it was still well in excess of the Fed’s target rate of 2.0%. In response, the Federal Open Market Committee (FOMC) twice increased the target Fed Funds rate by 75 basis points, leaving it currently at 3.0% – 3.25%. With two more meetings scheduled in 2022, most FOMC participants expect that the Fed Funds rate will continue to be increased into 2023 and that inflation will not reach the Fed’s target rate before 2024. Also, consistent with prior plans, the FOMC accelerated the rate at which it is reducing its $8.9 trillion balance sheet (holdings of Treasuries and mortgage securities) to $95 billion per month. At this rate, it will take until 2026 for the Fed to bring its holdings of securities to pre-pandemic levels.
Treasury yields continued to rise in the third quarter with short term rates rising substantially faster than long-term rates. (The one-month Treasury yield increased 166 basis points while the 10-year yield rose by only 82 basis points.) With this rise in yields, the broadest measure of the fixed income market, the Bloomberg Aggregate Index, declined in line with the S&P 500 in the third quarter, although shorter term Treasury and corporate bonds had smaller losses. Year to date, the longest-term bonds, both Treasuries and corporates, have lost more than the S&P 500, a reflection of the extremely low starting yields and the risk of longer duration assets. By contrast 2-year Treasury Notes and intermediate corporate bonds lost only 4.6% and 11.8%, respectively.
Market Environment
As Jerome Powell’s Jackson Hole speech in August and the FOMC minutes from September make clear, the Federal Reserve is committed to raising the Fed Funds rate enough to bring inflation in line with its 2% target. Interest rates are a very blunt tool for fighting inflation, especially when that inflation has significant sources in supply-side constraints, including labor and energy markets. Although monetary policy changes affect some sectors of the economy quickly (e.g., housing), they operate with a lag on other sectors. But rather than waiting to see the full effect of rate increases, FOMC members have stated their intention to keep increasing rates until they see the rate of inflation approaching their target. In addition to raising short-term interest rates, the Fed is also attempting to slow the economy by selling bonds to shrink its balance sheet. By increasing the supply of bonds in the market, the Fed essentially produces higher long-term interest rates.
With most other central banks maintaining short-term rates lower than the U.S., the dollar has appreciated substantially against most other currencies over the last few months. This has the effect of increasing prices in those countries for dollar denominated assets (e.g., energy), lowering the price of imports to the United States, making our exports more expensive for foreign buyers, and reducing the dollar-reported foreign earnings for U.S. multinational corporations. (Approximately half of the S&P 500 earnings come from outside the United States.) The higher rate of inflation in Europe, along with cutbacks in energy consumption to cope with Russian supply reductions, almost guarantees a European recession which will not leave the U.S. unscathed.
Recent turmoil in the British government bond market illustrates how a rapid and substantial increase in interest rates can produce unintended market and economic challenges in unexpected places. Over the last decade of low interest rates, large defined benefit pension funds and insurance companies in the United Kingdom, like investors everywhere, premised their investment strategy on the assumption that rates would remain low. Supported by regulators, they employed something known as a “liability driven investment” which, among other things, used leverage (in the form of derivatives) to enhance the yield on long-term government bonds. This strategy worked well so long as rates remained low but looked increasingly risky as rates rose this year. The Fed’s 75 basis point rate hike on September 21, followed by the Bank of England’s 50 basis point hike the next day, and the following day’s introduction of an inflationary fiscal plan by the U.K. government proved to be a tipping point. Long-term government bond yields spiked, leading to significant losses on those leveraged bond positions. As investors sold bonds to limit their losses, yields increased further. This rapid destabilization of the government bond market led the Bank of England to reverse its recently announced inflation-fighting policy of selling bonds and turn, instead, to buying bonds in order to reduce yields. Ironically, this last action only exacerbates the inflation problem higher rates are meant to address.
Although the strength of the U.S. consumer’s balance sheet may increase the time that it takes to cool inflation, the Fed’s determination is likely to result in lower investment, reduced consumer spending, and an easing of the still tight labor market. Even if the Fed were to stop increasing short-term rates, the continued run-off of its bond holdings will lead to higher long-term rates and, without the Fed as a buyer, less liquidity. It is certainly possible that the combination of higher rates and less liquidity could produce an unexpected and significant shock to our non-bank financial system, such as that seen in the U.K. In that case, the Fed might be forced to reverse course and we may end up living with higher inflation for a lot longer. Thanks to unprecedented levels of debt taken on over the last three years, this higher rate of inflation would likely be accompanied by reduced productivity and slower economic growth. It’s not a pretty picture, but certainly it’s one that investors need to consider.
Focusing on Long-Term Results
These remain challenging times for all investors. Navigating the risks in this market environment requires consistent focus on long-term goals and an appropriate allocation of assets. At Buckhead Capital, we work hard to help our clients clarify and achieve their financial goals. We try to understand the lessons that markets have provided and to use that knowledge in structuring portfolios to preserve and grow our clients’ capital. We continue to emphasize achieving an appropriate return for the risk taken. We do this not only through asset allocation (the mix of stocks, bonds, and cash) but also through individual security selection, sector weightings, and, in fixed income, target portfolio maturities/durations. This attention to risk management has historically produced better risk-adjusted returns over full market cycles. We continue to believe that this market cycle will be no exception.
