Stocks took investors on a roller coaster ride in the third quarter with an early summer rally ending abruptly after the Fed pledged to continue fighting inflation. Here’s a timeline of the highlights (and the lowlights):
- After a painful slide from the start of the new year, stocks staged a powerful rally off their mid-June lows.
- The summer rally peaked in July as both the S&P 500 Index and the Nasdaq Composite posted strong gains, lessening the recession fears that have plagued the stock market all year.
- Despite June inflation numbers coming in at 1% (among other discouraging data), upward momentum continued into the first half of August.
- The rally ended abruptly as rate hike concerns reasserted
- At the late-August Jackson Hole Economic Symposium, Fed Chair Jerome Powell’s speech reaffirmed the Fed’s hawkish stance and sent stocks lower.
- Stocks saw a brief upturn as September started, but lost momentum ahead of the September Federal Open Market Committee (FOMC) meeting in which the Fed announced its third consecutive 75-basis point hike of the year.3
Though the markets anticipated the change in interest rates, the Fed’s dim outlook surprised many investors, forcing them to confront the potentially unavoidable scenario of an economic hard landing.
Despite the recent market volatility around inflation and interest rates, markets seem to be pricing in a worst-case scenario. However, we are seeing some positive signs on the inflationary front, and the medium to longer-term outlook may not be as dire as markets would suggest.
ECONOMIC CONDITIONS: Uncertainty Abounds
U.S. – STRONG JOBS, HOUSING WEAKENS
GDP: The third estimate of Q2 GDP growth was -0.6 percent on an annualized basis.
The personal consumption expenditures (PCE) price index was revised higher by 0.2 percentage points to 7.3 percent, indicating continued inflationary pressures. 
LABOR: Employers added 315,000 jobs in August. The unemployment rate rose to 3.7 percent, up from last month’s 3.5 percent level, though the jump was largely attributed to an increase in the labor participation rate (from 62.1 percent to 62.4 percent). Wages continued to grow, rising 0.3 percent in August and 5.2 percent from a year ago. 
HOUSING: Housing starts rose 12.2 percent in August, propelled by a 28.6 percent increase in multi-family housing starts.  Existing home sales fell 0.4 percent from July to August and 19.9 percent from a year ago. The median sales price dropped for the second straight month.15 New home sales climbed 28.8 percent representing the second biggest increase on record. The median price of new home sales fell from a record high of $458,200 to $436,800. 
INTERNATIONAL: Slowing Growth
Headwinds to global economic growth continued to build in the third quarter. The International Monetary Fund (IMF) now projects that global economic growth will decelerate to 3.2 percent in 2022 from its earlier estimate of 3.6 percent.  China’s zero- COVID policy has continued to slow its economy and strain global supply chains, causing the IMF to lower its estimate of China’s 2022 economic growth to 3.3 percent, the lowest rate in four decades, excluding the COVID pandemic period of 2020 .
Economic conditions in Europe are also a concern as Eurozone economies remain depressed by accelerating inflation, strained supply chains, the war in Ukraine, and economic slowdowns in China and the U.S., Europe’s largest trading partners. 
Japan’s economy is facing challenges as well, though less acute than in Western economies. The Bank of Japan revised its economic growth projections to be lower due to weakened global economies and continued supply chain constraints. 
EQUITIES: Inflation Continues
U.S. EQUITIES: The Dow Jones Industrial Average dropped 6.65 percent during the quarter. The Standard & Poor’s (S&P) 500 Index fell 3.83 percent, while the Nasdaq Composite lost 2.64 percent.  Many sectors were lower in Q3, but Energy (+0.71 percent) bucked the trend. Elsewhere, Communications Services lost 11.76 percent, Consumer Discretionary fell 3.62 percent, and Consumer Staples dropped 7.55 percent. Meanwhile, Financials dipped 3.47 percent, Health Care slipped 5.56 percent, Industrials declined 5.15 percent, Materials fell 7.60 percent, Real Estate lost 11.87 percent, Technology slipped 6.73 percent, and Utilities dropped 6.59 percent. 
DEVELOPED INTERNATIONAL EQUITIES: Eurozone shares experienced further sharp falls in Q3 amid the ongoing energy crisis, rising inflation, and consequent fears about the outlook for economic growth. Every sector posted negative returns, with the steepest falls for communication services, real estate and healthcare. Some pharmaceutical stocks were hit by worries over potential liabilities related to U.S. litigation around heartburn drug Zantac. The real estate sector has been pressured by rising bond yields. The European Central Bank raised interest rates in July and September, taking the deposit rate to 0.75%. Annual inflation for the Eurozone was estimated at 10.0% in September, up from 9.1% in August. U.K. equities fell in Q3 amid political turmoil surrounding the election of Liz Truss as new Conservative Party leader and hence as prime minister. Truss presented a poorly received fiscal package which was quickly followed by a nosedive across U.K. markets. The pound appears to be making a comeback of sorts in Q4 after Truss resigned only 44 days into her pivotal role.
EMERGING MARKETS: Emerging market (EM) equities posted negative returns in Q3 against a backdrop of slowing global growth, heightened inflationary pressure, and rising interest rates.
The Russian war in Ukraine escalated and led to an energy crisis in Europe, which in turn has contributed to accelerating inflation. Poland was the weakest index market, with Hungary and Czech Republic also among the biggest decliners. China also underperformed by a significant margin. Not only has a slump in the property market weighed on investor sentiment, the imposition of COVID-related lockdowns in various major cities has had a negative impact on domestic demand.
Growth-sensitive north Asian markets such as South Korea and Taiwan suffered as the outlook for global trade deteriorated. Colombia also performed poorly as commodity prices fell, while the Philippines and South Africa lagged amid concerns about the power situation.
FIXED INCOME: Under Pressure
U.S. FIXED INCOME: AIn September, the FOMC issued new projections suggesting that interest rates may be increased by another 1.25 percentage points by December. It also said unemployment may rise to 4.4 percent by the end of 2023 (up from August’s 3.7-percent level), and that interest rates may reach as high as 4.6 percent in 2023, with a rate cut unlikely until 2024. 
DEVELOPED INTERNATIONAL FIXED INCOME: Government bond yields were generally higher and credit spreads wider across the global market which weighed heavily on market returns. The credit spread is the difference in yield between bonds of a similar maturity but with different credit quality. Credit spreads widened amid fears that tighter monetary policy may undermine further economic growth prospects.
Across global credit, returns were poor as the market drawdown continued. Sterling investment grade and high yield were the worst performers. European investment grade and high yield, as well as emerging markets credit, fared better but only on a relative basis as returns remained negative. Investment grade bonds are the highest quality bonds as determined by a credit rating agency; high yield bonds are more speculative, with a credit rating below investment grade.
Emerging market currencies weakened as investors fled to the U.S. dollar on recession fears. Central and eastern European currencies were mixed against the euro.
QUARTERLY FOCUS: Talking Tough
The implicit message that was in the projected estimates was made explicit by Chair Powell at the late September press conference: the Fed’s first priority is to get inflation back to its target rate of 2%. He reiterated the central bank’s commitment to achieving that goal even if it meant compromising economic growth to get there. As a result, some would argue that the Fed has backed itself into a corner by waiting too long to acknowledge that this inflation is not transitory and is now behind with its attempts to combat the problem. Inflation numbers reached 40-year highs earlier in 2022, and the Fed’s initial lagging response has led to reactive, aggressive rate increases. Recent higher-than-expected Consumer Price Index (CPI) numbers are adding to the difficult task of combating inflation without driving the economy into a recession.
The key driver going forward will be inflation data. Inflation metrics like consumer price index (CPI), producer price index (PPI), and personal consumption expenditures (PCE) will be closely watched as markets seek any signs of inflation slowdown. While the recent CPI reading and most recent Fed meeting painted a bleak picture, there may be signs of relief ahead:
- Gasoline prices fell -9% in August and the trend continued through
- Stabilized natural gas prices will soon trickle down to utility
- Significant declines in grain, dairy, and other agricultural prices will soon drive down grocery store pricing.
- Used vehicles are selling for significantly less at auction in recent
- Supply chain improvements will drive down consumer goods inflation, and the stronger dollar will continue to push down the prices of imported goods (which fell -1.0% in August and -1.5% in July).
- Private-sector measures of rents have slowed
- Travel-sensitive categories including hotels and airlines have seen declining prices recently.
- Healthcare costs are trending lower according to the personal consumption expenditures price index (PCE).
- According to Chairman Powell, inflation expectations are well-anchored, suggesting that the risk of a wage-price spiral is negligible.
- Core crude PPI (ex-food and energy – at the very early stages of production) has deflated -1.6% Y/Y in August. A year ago, at this time, this was +42%!
As seen in the chart below from JP Morgan, market and professional forecasters’ longer- run inflation rates have dropped significantly from their peaks, despite the fact that the recent CPI numbers have remained high.
It is clear the Fed is moving forward with strong hawkish policy. Rising interest rates have markets fearing the worst and looking for any modicum of good news on the inflation front to lift spirits – and stock prices. While this inflationary surge will surely take more time to ease than most had originally expected, disinflationary momentum could provide the comfort that markets have been looking for.
DPWM OUTLOOK: Patience for a Strong Recovery
In principle, we believe that long-term investors should remain invested across market cycles and that trying to time the ups and downs of those cycles is a fool’s errand. The Fed has embarked on an important task. While we don’t want to underestimate the challenges of a recession, like many investors we believe that the perils of high inflation are worse. Those of us under the legal retirement age have never lived through a prolonged period of high inflation nor experienced its destruction firsthand. While inflation is high in the U.S., relative to recent history, it remains higher around the world. We believe that the U.S. will come out of this difficult period with a stronger economy and more rational valuations across a wide range of asset classes. This may set the stage for strong investment returns:
- The average S&P 500 return in the 12 months following an inflation crest was 11.5%.
- The average 12-month [equity] return immediately following a 15% or greater decline is 55%.
- Bear markets average 20 months in length with an average return of -41%, a relatively short time compared to bull markets that average 51 months and an average total return of 162% (see table below). 
Rather than seeing this as a time for pessimism, we see it as a time for cautious opportunism, particularly around financial planning work. For example, with interest rates on CDs and Treasuries topping 4% , one can finally earn an attractive return on savings. Many Americans have hesitated to even save an emergency fund given the dearth of return on savings, but now may be the time to reassess one’s allocation to cash savings, which is likely an under- invested portion of their financial plan. Within portfolios, we take advantage of higher interest rates by purchasing treasury bonds which are now yielding over 4%.
Now may also be a good time for tax planning, such as exiting legacy positions that may have been difficult to liquidate when asset values were higher. Given where asset values are today, there can be attractive opportunities to execute tax-loss harvesting across taxable portfolios.
In short, we believe in staying the long-term course. Investors are experiencing the end of the longest bull run in American history. Markets have been and will likely remain choppy. Growth is expected to be tepid. We may see a recession. Global supply issues may take longer than we’d like to work themselves out. But in the end, the volatility due to the uncertainty above presents opportunities to put money to work at more favorable valuations across bond and stock markets.
1. WSJ.com, September 30, 2022
2. CNBC.com, July 13, 2022
3. CNBC.com, September 21, 2022
4. SectorSPDR.com, September 30, 2022
5. Reuters.com, August 31, 2022
6. IMF.org, July 2022
7. IMF.org, July 2022
8. EuropeanCentralBank.eu, September 2022
9. BankofJapan.or.jp, July 2022
10. BEA.gov, September 29, 2022
11. CNBC.com, September 2, 2022
12. WSJ.com, September 15, 2022
13. FederalReserve.gov, September 15, 2022
14. MarketWatch.com, September 20, 2022
15. CNBC.com, September 21, 2022
16. Realtor.com, September 27, 2022
17. WSJ.com, September 13, 2022
18. WSJ.com, September 27, 2022
19. CNBC.com, September 21, 2022
PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS.
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