Quarterly Commentary - Q3 2022 Recap: A Broken Record Stuck on a Terrible Song

SUMMARY:

• Tough quarter once again for stocks and bonds
• Tactical outlook remains challenging
• Valuation reset gives us hope for the future

Quarterly Recap: Inflation Remains the #1 Issue; Rates Are Higher, But Earnings Hang On

While it may seem like a faint memory, Q3 2022 began on a somewhat optimistic note. Inflation – especially gasoline prices – appeared to have peaked and there was a hope that inflation would moderate quickly, appeasing the Fed and avoiding a recession. Q2 earnings were lower than the previous year but still strong – making the case for a soft landing and providing hope the market might look through the economic slowdown. This prevailing view from July through mid-August created a short-lived bear market rally for equity and credit markets.

Then came Fed chair Jerome Powell’s speech at the annual Jackson Hole conference. He used it to place a clear emphasis on reducing inflation to 2%, even at the cost of a recession. The clarity of this message brought this calm to a halt. Shortly thereafter, the August Consumer Price Index (CPI) report was more elevated than expected. The realization that inflation is still in the windshield and not the rear-view mirror, so to speak, coupled with Powell’s crystal-clear determination, effectively ended what has been known for years as the “Fed Put”. The Fed Put is a widely held belief that the Fed will step in to buoy the markets with monetary accommodation. The equity market’s response was a complete reversal, a lower low for the year and levels not seen since 2020. For both stock and bond investors, Q3 probably felt like a broken record stuck on a terrible song.

Bond investors faced similar challenges in the quarter. Interest rates across the yield curve have risen both directly as the Fed raised the Fed Funds rate, and indirectly through the Fed’s strong rhetoric against inflation. The rate increases sent shock waves through the bond and equity markets at the same time, roiling balanced investors, who are used to some measure of downside protection from their bond portfolio in down markets. The ten-year Treasury bond yield briefly went over 4% in overnight trading before closing the quarter at 3.83%. The effects of the dramatic increase in rates will affect housing, the consumer, and the US economy broadly in Q4 and beyond.

Not only are US interest rates rising domestically, but also relative to the rest of the world. This resulted in a strengthening dollar in our view, which jolted non-US markets as many foreign currencies hit multi-decade lows vs. the dollar. Europe faces additional challenges with the annexation of Ukrainian territory by Russia and the stoppage of the Nord Stream Pipeline – the primary supply of natural gas from Russia to Europe. This will prove a challenge to their fight against inflation in the 4^th quarter.

Returns Recap: Nowhere to Hide in Q3, Just Like Q2

From a returns perspective, the Q3 seemed to largely be a continuation of challenges of the previous three quarters. Two of the assets most commonly used to hedge equities – bonds and gold – both performed poorly as rising rates have harmed bonds at the same time as stocks in our view. The shifting perception of the Fed as an inflation fighter and the lack of any yield has also weighed on gold. While cash appears to be a haven, that is somewhat illusory against increasing inflation. In the long run, the loss of purchasing power is an important risk to guard against, since lost purchasing power can often be permanent, while stock market losses are often temporary.

Most International Markets Performed Similarly to US, Dollar Strength Was Real Pain Point

The table below shows that local markets in developed markets have largely moved consistently with US Markets, and that the underperformance of international markets has largely come from the currency – China is a notable exception, as they face issues with rapidly slowing growth and continued COVID-19-related lockdowns, which has dragged down overall Emerging Market returns.

Outlook: Q4 is Looking Challenging, But There is a Case for Longer-Term Optimism

Given the short-term uncertainties discussed in this piece, we are cautious on equities across all balanced portfolios versus our benchmarks. Indeed, last week we reduced equity weightings. As a result, in our shorter-horizon portfolios, we are close to our COVID-19-level lows in equities, and our fixed income strategy still favors corporate bonds with shorter maturities.

Our longer-horizon portfolios are also below the equity weighting in their benchmarks, but less so. In these portfolios, we have sought out high yield bonds and other alternative yield-oriented securities in an effort to increase expected yields across the portfolio, as well as favoring energy-related and technology companies versus cyclical consumer themes. The reason we are not at historically high levels of cash is that stocks and bonds have already fallen significantly, making them both attractive to us on a longer-term basis. Given this, there is a case for longer-term optimism even as the shorter-term tactical outlook remains fraught with uncertainty.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.