Q3 2022 Market Perspective

Stocks have declined for three consecutive quarters and investor sentiment is at historically low levels. Investors have increasingly grown pessimistic about the Federal Reserve’s (Fed’s) ability to navigate a soft economic landing as it attempts to curb rampant inflation by slowing economic activity. The Fed has raised interest rates aggressively over the past few months and has maintained its position that achieving price stability is the number one priority, no matter the consequence.

In mid-July the S&P 500 index rallied significantly after a series of poor economic reports led investors to believe that the Fed would respond with a pivot away from its hawkish (i.e. higher rates) narrative sooner than expected. This momentum was short-lived, as Fed Chairman Jerome Powell reiterated his commitment to raising interest rates in late August, stating, “the unfortunate costs of reducing inflation”, will require a “sustained period of below-trend growth”. [1] Simply said, the Fed wants everyone to understand that entering a recession is an unavoidable consequence of its actions to tame inflation.

Some investors believe that we are currently in a recession, as two consecutive quarters of contracting GDP is a commonly accepted definition of a recession (which has occurred in Q1 and Q2 of this year). Regardless of when a recession is declared, investors today are concerned with how deep it will be and how long it will last. This uncertainty has resulted in persistently high levels of market volatility in equity and fixed income markets.

We believe that higher interest rates are ultimately a long-term positive for the economy. The road to that point will continue to be a rocky one from here. The Fed has a difficult job to do, for reasons both within and outside of its control. The risk of tightening too far is a real immediate threat. And even though we expect the Fed will have an opportunity to moderate its restrictive policy in the first half of next year, this means further short-term pain on the path towards low and stable inflation and ultimately sustained long-term economic growth.

Q3 and Full Year 2022 Market Returns

• Index returns [2]:

Major Asset Class Returns in Q3 2022

Source: 2022 Total Return as of 09/30/22, Bloomberg

The Fed’s Plan & How It Will Impact Markets

The Fed began raising rates back in March of this year, the first time it had increased the Fed funds rate since 2018. There have been five rate hikes this year, and the last three of those were historically high increases of 0.75%. The target rate is currently a range of 3.0% to 3.25%. The current implied peak rate is projected to be roughly 4.86%, expected in March 2023. [3] This suggests the Fed will raise rates another 1.6%, and with rate decisions scheduled for November and December, they are expected to be a lot closer to this target rate by year end.

The change in these projections has been a material contributor to market volatility this year. For comparison, the peak implied rate was almost a full percentage point lower a few months ago and as expectations for higher rates increased, the market has been pushed lower. It is important to note that the Fed funds rate expectations also project that the Fed will begin lowering rates in the second half of 2023, with the implied target rate dropping to roughly 4.5% by the end of 2023. [3] In other words, because the Fed’s interest rate policy is one of its most effective tools in directing economic activity, one of the reasons to be aggressive now is to have the opportunity to eventually lower rates and stimulate the economy. This is all a moving target and why the “soft” and “hard” landing conversations are difficult to project.

The Fed has also taken a hardline approach in its narrative to guide public expectations about future inflation. This is a powerful tool in controlling inflation as consumers and business owners will make spending, saving, and hiring decisions based on their expectations. The Fed also wants to act swiftly, knowing that inflation is more difficult to get under control after it becomes entrenched in the economy.

In the chart below we illustrate how the S&P 500 index returns and inflation expectations have moved in opposite directions all year long. Inflation expectations (grey line) rose steadily for most of the first half of the year (first shaded area) while the S&P 500 index (blue line) declined during this period. When inflation sentiment shifted briefly over the summer, the S&P 500 index rallied significantly off its lows. More recently, inflation fears have risen again, while the S&P 500 index once again faced downward pressure (see third shaded area).

Source: Bloomberg; Inflation Expectations & S&P 500 index price returns

Additional Near-Term Undercurrents

The Fed stands alone at center stage yet there are a few notable events that could shape market volatility in the near-term.

• Midterm elections are on November 8th and many seats are up for grabs within the House of Representatives, Senate, and state and local governments. While volatility is often elevated leading up to midterm elections, it’s possible that the outcome could be favorable for the market. If the Republican party makes gains in the election, it may help market sentiment since a gridlocked government reduces the likelihood of legislative changes.
• Putin’s war on Ukraine has such extreme binary outcomes it’s nearly impossible to predict. On the one hand, a quick end to the war would remove a cloud of uncertainty and ease inflation in the food and energy markets, which may result in market gains. On the other hand, further escalation (e.g., the use of chemical or tactical nuclear weapons) could lead to deeper food and energy shortages and possibly short-term market declines.
• The University of Michigan consumer sentiment index is at a historically low level, which can be viewed as an indication that market sentiment is bottoming. [4] When sentiment has reached current levels, historically, the S&P 500 has experienced favorable returns over the subsequent 12-months.

Summary

We believe the market will continue to endure heightened volatility as investors grasp at signs the Fed will slow its pace of tightening economic activity. For this to happen we need to see positive improvements to inflation as well as signs that the economy is reacting to the Fed’s restrictive measures.

The strength of the job market today is a double-edged sword. Current low unemployment and strong wage growth are typically representative of a strong consumer and a strong economy, however they can also lead to (or are signs of) higher inflation. Managing both underscores the challenge of the Fed’s balancing act today. If we look at the current yield in short-term US Treasury bonds, we expect the Fed has a little more work to do (i.e., get rates above 4%) before it will consider pausing.

As we navigate through the uncertainty of how long the Fed’s tightening cycle will last and the magnitude of the resulting decline in economic activity, we remain committed to our investment process. We understand that challenging market environments can leave some investors unsettled. However, these periods of time historically have presented opportunities for long-term investors. The opportunities will vary by individual but staying committed to your plan does not mean sitting on your hands.

We are actively rebalancing portfolios and executing tax loss harvesting strategies. Where appropriate we are taking advantage of depressed equity values or adding allocations to higher yielding fixed income investments. In other words, we are prepared to confidently ride out this volatility and remain positioned to take advantage of a positive shift in market sentiment.

Gregory Slater, CFA, CFP®, CIPM®

Partner, Chief Investment Officer

Appendix

Chart A: 2022 Total Return of Major Asset Class Indexes

Source: Bloomberg; 2022 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes

1 – Jerome Powell Speech at Jackson Hole. https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm

2 – Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index

3 – Bloomberg WIRP, World Interest Rate Probability.

4 – https://tradingeconomics.com/united-states/university-of-michigan-consumer-sentiment-index-1st-qtr-1966-100-m-nsa- fed-data.html