2022 3rd Quarter Market Commentary
Top Headline for Q3: Resolute Central Banks Sinking Risk Assets
The challenging market environment continued in Q3. Central banks, most notably the U.S. Federal Reserve Bank (the “Fed”) have been firm in their stance that inflation is enemy number one. In attacking inflation, the Fed has aggressively increased interest rates beyond most of our expectations which, as would be expected, has pummeled long-term fixed-income assets and risk assets generally (e.g., stocks). As measured by the S&P 500 Index, the U.S. stock market was down 24.8% through September 30. Similarly, the bond market, as measured by the Bloomberg U.S. Aggregate Index was down 14.4% through September 30.
The Fed effectively controls short-term interest rates but has less control over long-term rates which are a key driver of “risk asset” performance. Long-term rates are driven more by long-term inflation expectations which are a function of factors like demographic changes, GDP growth and changes in productivity. It is noteworthy that the yield curve is currently inverted. Long-term rates are refusing to follow the path upward, resulting in short-term rates that sit above long-term rates. This process can lead to short-term volatility as the market tries to establish a foothold. We saw this process play out in recent months. After peaking at about 3.5% in mid-June, the rate on the 10-year treasury bond dropped dramatically to about 2.5% in early August. The 10-year continued its volatility, hitting 3.99% on September 27th, before ending the quarter at 3.8%. The impact of long-term rates on the stock market was on full display during the quarter. As interest rates dropped early in Q3, stocks were in rally mode. But, as rates shot higher, stocks responded by dropping precipitously. The long-term fixed income market has already “priced in” an aggressive tightening path by the Fed. As a result, we believe the fixed income market is looking more attractive than it has over the past couple of years.
General Market Update
US Equities: As has been the case most of the year, there were very few places to hide in the equity market in the 3rd quarter. The S&P 500 Index was down 5.3% during the quarter; the Nasdaq Composite was down 4.1%; and the Russell 2000 Index dropped 2.5%. Although most sectors are down, there is a clear “loser” this year. The rising rates have punished the Technology sector more than others as earnings from these companies are pushed further into the future and are thus hurt the most by a rising discount rate. As evidence, the Technology ETF, XLK, was down 6.3% for the quarter and is down 31.2% YTD. The market selloff in September was especially sharp. After bouncing from June lows, the S&P 500 fell a staggering 9.3% in September alone. During the 3rd quarter, we continued to rebalance and worked to take advantage of the market volatility. IRA portfolios saw a "defensive" rebalance earlier in September which set aside some cash and shifted some equity allocation to more defensive sectors of the market. Late September, we deployed another rebalance after the S&P 500 had dropped by an astounding 15.3% from August 16th to September 27th. We believe, according to several indicators, that the market currently sits at an attractive entry point in the short term. We will continue to monitor markets and adjust portfolios accordingly.
International and Emerging Market Equities: The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was down 10.6% in Q3 and the Schwab Emerging Markets ETF (SCHE) fell 11.7%. In general, foreign markets have a lower allocation to the technology sector. However, other issues persist. For example, Europe is presently facing a more severe inflation problem than the U.S. along with rising geo-political tensions and an energy crisis sparked by the Russia-Ukraine conflict. Elsewhere, China has witnessed a total collapse of its real estate sector and lower growth as rolling Covid lockdowns continue throughout the country.
Fixed Income and Credit: The bond market slide continued during Q3 across all durations. However, as covered above, the long-term bond market appears to be trying to stabilize. Long-term corporate and treasury bonds have now fallen close to 30% for the year and are now attractively priced by many measures. Many longer-dated bonds are trading at a yield that is above long-term inflation expectations. This suggests a positive “real” yield which could indicate that the carnage may soon subside. Patina clients benefited from a substantial overweight to shorter-duration bonds during the quarter and in 2022, and we will look to increase exposure to duration as the markets continue to stabilize.
Commodities, Precious Metals, Inflation: Inflation has proven to be higher and more persistent than most people predicted. However, several indicators suggest that inflation has now peaked. As an example, home prices fell for the first time since 2012. Similarly, rent prices have also begun to come down. The key questions going forward are “How far will inflation fall and how fast?” The Fed’s “target” is 2% but many economists think inflation will settle at a level higher for the foreseeable future. Inflation in commodities has been more episodic than persistent, and rising rates are likely to hurt demand and ease pressures. Inflation hedges, such as precious metals, have oddly underperformed during the present environment as investors have been slow to move away from traditional investments. If a period of “stagflation” (i.e., low growth & above average inflation) persists, it is likely that inflation hedges will benefit.
A Look Ahead
As we enter Q4, more attention than ever will be on the Federal Reserve Bank of the United States. Chairman Powell has indicated that there is no way to combat inflation without causing some pain to the economy. Although he won’t mention the word recession, this is what he is referring to. The key question is “How much damage is the Fed willing to cause before they inevitably pause?” Any pause in interest rate increases or a hint of a pause will be supportive of risk assets. Most notably, we would likely begin to see a flood of capital into longer-dated fixed income securities. It’s likely to remain challenging for the equity market should the Fed push the economy into a recession. On the equity front, choosing the right sectors and asset class styles (Value/Growth) will be more important than ever.
Please feel free to reach out during this heightened period of volatility. We are more than happy to walk through portfolio allocations and the rationale behind various positions. We’re hopeful that much of the storm is behind us at this point and are excited about the opportunities ahead.
