Q-3, 2022 MARKET REVIEW:
Where We Are
Reflecting on the economic outlook and resulting market gyrations that defined the quarter, the words of the American pamphleteer Thomas Paine come to mind. “These are the times that try men’s souls”.
Today’s financial market losses are indeed bracing but come on the heels of almost thirteen-years after the Great Recession. In the interim equity investors enjoyed a 14.25% annualized growth of the S&P 500. Low interest rates, globalization and supportive monetary practices all contributed to this growth. Reversals in all the forementioned now fuel today’s market decline. Additionally, inflation precludes the Federal Reserve stepping in with policies that might limit further stock market declines.
Fiscal and monetary intervention staved off the worst of the Great Recession and remained in place for much of the ensuing decade. In 2020 the worldwide pandemic further scrambled economic and financial market dynamics. Manufacturing and business activity were shuttered or scaled back. Global supply chains were interrupted or severed. Consumers increased saving and reduced consumption. Unemployment rose. Government and central banks expanded fiscal and monetary policy initiatives to offset the impact of the economic slowdown. The resulting increase in money supply fueled investor receptivity for riskier investments.
As quickly as the economy closed in 2020, within a year COVID vaccines allowed an economic reopening and return to a new normalcy. Pent up consumer demand for goods and services increased faster than manufacturers and businesses could rehire, resume production and reinstate supply and distribution networks. When demand outstrips supply, inflationary pressures follow. What was initially perceived as transitory soon became embedded. Economic shuttering and reopening played out in varying time periods across the global economy precluding a one and done response that might otherwise have corralled inflationary dynamics.
Inflation and Interest Rates
The Federal Reserve Bank is now singularly committed to returning inflation to its targeted rate of 2% annually. It has at its disposal relatively rather blunt monetary policy tools to pursue this objective.
Changes to interest rates with the resulting slowdown of economic activity percolates through the economy with some lag factor. Slowing inflation requires slowing economy activity and a slowdown in economic activity invariably means worker unemployment. Because of the time it takes the economy to digest and respond to a change in monetary policy, there is little ability to know exactly what amount of slowing achieves the desired goal. Too much slowing tips the economy into recession. Maneuvering a soft economic landing has consistently alluded central banks. The prospect of recession is, therefore, real. The more salient question is how deep and extended must any slowdown be to reduce inflation to an acceptable level.
In the third quarter, the Federal reserve increased its benchmark rate by 1.25%. In January 2022 that rate was effectively zero. By September 30, it was 3.25%. The central bank has reversed its purchases of financial instruments and is now a seller in an effort to reduce financial liquidity.
Because the US dollar is a reserve currency held by official institutions and the preferred currency for most financial transactions, an increase in US interest rates is problematic globally and particularly for emerging economies. Higher interest rates increase the cost of financial transactions and the servicing of external debt. Efforts to reduce U.S. inflation by raising interest rates will have a knock-on effect to the global economy.
Technically, two consecutive quarters of negative economic growth define a recession. The US economy has now recorded two such quarters. The University of Michigan’s consumer confidence survey is at its lowest levels in 50-years. Off-setting these negatives, are that US job creation remains strong and continues to suggest a resilient economy. Job creation contributes to household income gains. And, in the 12-month period ending July 2022, wage and salary income rose 10% and average hourly earnings increased 5.2%.
Specific to the equity markets, higher interest rates reduce the discount rate used to value future corporate income. The higher the discount rate the lower the projection of growth and corporate profits and the share price an investor is willing to pay.
Equity rallies in July were followed by steep declines in August and September. The idea of buying the dips is proving an unsuccessful investment strategy when the terminal value for interest rates remains uncertain.
The next market destabilizer will undoubtedly be the change in corporate earnings as consumers and businesses reduce spending. Corporate valuations are now below their 25-year averages. The US markets currently trade on a price-to-earnings ratio of 15.6 versus its long-term average of 16.6. Further change to those earning assumptions will result in further declines in the share price of companies vulnerable to further economic slowdown.
In the face of the above, portfolio diversification strategies remain challenging. Bonds have traditionally hedged against equities with countercyclical prices and rates, though for the past several years that relationship was compromised in an environment of low inflation and interest rates. In 2022, bonds have offered an alternative to the losses investors are experiencing in the equity holdings. A recession should stabilize or reverse interest rate increases. However, the amount of government debt outstanding could keep rates high despite reduced corporate borrowing.
Real estate asset investing traditionally has limited correlation to investing in equities and debt instruments. Today’s losses in real estate are traceable to the dynamics of a reopening economy. Commercial real estate is attempting to find its legs in an environment characterized by continued work from home practices, which limit the demand for commercial office and related facility space.
Residential housing prices and demand skyrocketed as self-quarantining ameliorated. Home-buyers and renters scrambled for properties, driving home prices and rents higher. Low mortgage rates fueled demand. In the past twelve months mortgage rates have now doubled dampening housing demand and new-housing construction starts and reducing returns from this asset class.
Key Markets- X U.S.
United Kingdom data indicate a loss of positive economic momentum. Consumer confidence fell to an all-time low in September 2022 and the business purchasing managers index hit its lowest level since 1974. Year on year core inflation has increased from 6.2 to 6.3%. Further increases driven by energy prices are expected in the fall and winter months.
The government of Prime Minister Liz Truss rolled out a new budget plan that heralded an increase in government borrowing. This destabilized the British currency and substantially increased borrowing cost forcing the Bank of England to increase liquidity in an effort to ameliorate the upward spike in interest rates impacting pension systems and mortgage rates. Subsequently, the government back-tracked on certain elements of its controversial policies. Regardless, interest rates have more than doubled from the beginning of the quarter-to-quarter end.
Europe scrambles to stave off a recession. Industrial production is down, consumer confidence is at an all-time low and inflation is in large part driven by climbing energy prices. The war in Ukraine fractured the relationship between Europe and its traditional energy supplier, Russia. A summer long scramble to shore up energy availability has resulted in winter storage supplies of 85% of regional capacity. This reduces the more draconian expectation of wide spread energy supply shortages in the coming winter months.
China continues to pursue its zero COVID policy shuttering large cities and regions in an effort to stamp out the virus. The resulting disruptions to manufacturing, distribution and internal consumer demand has negatively impacted economic growth projections in 2022. The weakness in China’s housing market results from over-building and the inability of some real estate development groups to service international debt obligations. Liberal government financial policies are helping address economic dislocations.
The below illustrates the breadth of change in the domestic equity and debt markets over the past three months.
|US S&P 500**
|Growth (MSCI World Growth)**
|Value (MSCI World Value)**
|Small Cap (MSCI World Small Cap)**
|Barclays US Aggregate Bond Index (USD)
* ycharts.com Data
**Asset Class Data: JP Morgan, Quarterly Review of Markets
We continue to remain on the sidelines believing it preferable to not front-run a run-away train. Client cash needs have been addressed by either harvesting capital gains achieved over the past years or jettisoning investments that in our belief have lesser prospect for a quick rebound once economic and market forces change.
In the recent past there was limited impetus to consider bond funds considering the more favorable returns achievable from equity investments. The losses in most equity market sectors now contrasts with the positive returns available from fixed income investing, without the need to assume undue credit risk. We are directing available cash to intermediate term bond funds, tax-exempt as well as taxable. We are not generally exiting equity holdings to take positions in bond portfolios but will use new funds and proceeds from select equity sales to fund acquisitions.
As previously discussed, clients with investments pursuing dividend and or interest returns may see losses in the market price of these holdings as prices adjust to the similar market dynamic that impacts share prices. An environment of rising interest rates makes these investments, regardless of the projected return, less attractive until the terminal level of interest rates is known. Investors in these securities should, however, continue to receive the interest or dividend returns expected at the time the investments were made. The share price of these portfolios, similar to those of equity investments, will right themselves over time.
Vincent Juvyns, JP Morgan Asset Management Quarterly Market Review, 03-10-2022.
 Vincent Juvyns, JP Morgan Asset Management Quarterly Market Review, 03-10-2022.