Investment Commentary
The third quarter was another difficult one for both stocks and bonds. The S&P 500 declined 4.9%. International stocks fell as the value of the U.S. dollar rose over the quarter. Foreign stocks, as defined by MSCI ACWI ex USA IMI, declined 9.7%, inclusive of emerging markets, which declined 11.6%. The majority of the losses in foreign stocks for U.S.-based investors throughout the quarter were actually attributable to the strengthening U.S. dollar as the stocks were down less than 4% in local currency terms.
After increasing more than 2% during the month of August, the Bloomberg Aggregate Bond index finished the quarter down 4.8%. Both short-term and long-term interest rates moved dramatically as markets priced in additional interest rate hikes by the U.S. Federal Reserve (“The Fed”). The final weeks of September saw closing 10-year yields as high as 3.97% and as low as 3.37% as volatility remains elevated in government bonds.
Economic Outlook
Much has been made about whether or not the U.S. economy is in recession. While we’ve had two consecutive quarters of shrinking gross domestic product (GDP), many other hallmarks of a recession have been absent. However, shrinking GDP has been paired with declining real personal income (i.e. prices of goods and services have been increasing at a faster rate than wages). For relatively wealthy families, this is a nuisance. For many families, this is an economic disaster. Despite having a job, and likely earning a higher wage than in the recent past, many families are either reducing discretionary spending, borrowing to spend given higher prices, or a combination of the two. According to the Census Bureau, median inflation-adjusted household income declined 1.4% annually from 2019 to 2021. Given that real personal income has declined on a year-to-date basis, it seems likely this trend will continue for 2022.
Fed Chairman Jerome Powell highlighted on more than one occasion this quarter that the Fed understands that continuing to increase interest rates will create pain for consumers and businesses. He further noted that this will be tolerated as a side effect of their treatment for high inflation.
The Fed’s dual mandate of stable prices (inflation of about 2%) and full employment have rarely been at such odds in the last several decades. Both the labor market and inflation have been too strong over the last 18 months on the back of post-pandemic stimulus and unusually troubled supply-demand dynamics. With labor markets so tight, the Fed feels they have substantial room to aggressively raise rates and focus on fighting inflation before labor market conditions concern them enough to change their course on restrictive monetary policy.
Policy has clearly been too accommodative for too long, but now markets are grappling with the risk of policy becoming too tight too quickly. Further, the Fed has lost a significant amount of credibility with markets as inflation has run away over the last 18 months while the Fed generally incorrectly wrote off said inflation as transitory. It is important that the Fed regain credibility by appropriately tightening policy and getting inflation back under control. Paradoxically, they may be required to incite a recession in order for that credibility to be regained. Ultimately, in the short-term, tight policy has been bad for markets as higher rates generally negatively impact most asset prices. However, we believe that failing to get inflation under control is a much more serious risk for markets in the long-term.
While August unemployment increased from 3.5% to 3.7%, perhaps a sign that higher rates were already impacting labor markets on the margin, the September jobs report showed a decrease in unemployment back to 3.5%. While a reduction in unemployment is typically seen as positive, the market took this as a bad sign that the Fed will need to raise rates further and keep rates elevated for longer than previously expected. Both of these outcomes are generally negative for asset prices.
A tremendous amount of the economic and market outlook hinges on inflation. Outside of the official Bureau of Labor Statistics inflation reports, there are more contemporaneous data and anecdotal evidence that can clue us to the direction of inflation. Suffice it to say that the data are mixed, and as a result, the outlook is as cloudy as it has been in quite some time. A major risk is that inflation remains above trend, causing the Fed to increase policy rates higher than expected or rates will remain elevated longer that the market predicts.
Investment Strategy
As interest rates increased for the first two weeks of September, we increased the duration of client bond portfolios in most risk profiles. Portfolios are generally at the longest duration they’ve been in many years as we attempted to take advantage of much higher yields, and therefore lower prices, in intermediate term bonds. Generally speaking, bond yields across most fixed income sectors are at or near their highest levels of the last decade.
Despite volatility, no significant changes have been made to equity portfolios. Changes in price to earnings ratios have been roughly proportional to changes in interest rates, and thus have not created much incremental opportunity in our view, especially in domestic markets. We continue to monitor markets for opportunities to add to or reduce equity allocations in response to changing valuations.
It has been some time since markets ended an economic cycle on more traditional terms. In 2020 the market cycle ended as a result of an exogenous shock – a global pandemic and lockdowns. 2008 was a generational recession stemming from major structural issues with the global banking system and the housing market. 2000 was the result of a bubble bursting in dot-com stocks and extreme valuations across stock markets. A more traditional economic cycle consists of a recovery stemmed by accommodative monetary policy, followed by a mid-cycle period then a late cycle period generally characterized by overheating in sectors of the economy and a need for policy tightening which eventually brings about a slowdown and recession. The Fed has not been required to aggressively fight inflation since the early 1980s. The policy prescription is fairly straightforward, albeit painful.
Finally, it is always worth mentioning that the rampant negativity in financial media is generally reflected in asset prices today. Markets have had to very quickly adapt to the expectation that the Fed is likely going to hike rates by over 4% within a twelve-month period – a magnitude of policy tightening that we have not seen since 1981. High inflation has led to higher rates which has hurt stock prices and bond values. Eventually, falling inflation will lead to lower rates which should boost stock valuations and bond values. Timing in markets is inherently difficult and often the periods in which things seem like they can only get worse are often in hindsight the periods that have presented the best buying opportunities.
As always, we would encourage you to reach out if you have any questions or concerns about your portfolio or the current market volatility.