Q3 2022 Market Commentary
By Edward Miller, CFA®, CMT®
Through the 3Q, the pain continued for most markets. And when referring to “most markets,” this includes both equity and fixed-income markets – quite a rare occurrence. In the 1Q and 2Q of this year, both the S&P 500 and the Barclays US Aggregate Bond Index experienced negative returns, and that trend continued in the 3Q as the S&P 500 declined by -4.9% and the Barclays US Aggregate fell by -4.8%. It’s worth noting that three consecutive and concurrent quarters of declines for both of these indices has never occurred, dating back to 1976, the inception of the Barclays Aggregate Bond Index.
As inflation has remained stubbornly high, with the Fed responding by continuing to aggressively raise interest rates, bond prices have taken it on the chin, hard. But in this environment of monetary policy tightening and reduced liquidity, equites have also headed south as investors grapple with the possibility of entering a Fed-induced economic recession. It’s no wonder that apart from commodities, there are very few places for investors to hide.
As shown in the table above, year-to-date (YTD), most major equity indices remain in bear market territory (defined -20% or more from its peak). Making matters worse, the Barclays US Aggregate Bond Index is down by nearly -15% this year, having by far its worse year since its inception, with previously the worst year being -2.9% in 1994.
Fortunately, our portfolio positioning has been defensive since late last year and remains so through the 3Q. At this point, a common question we hear from clients is, “When will things turnaround and what will it take for that to happen?” As written in past quarterly letters, we have contended that as long as inflation remains elevated and the Fed maintains its very hawkish stance, both equity and fixed-income markets would remain weak. But once there were meaningful signs of inflation peaking and even subsiding, inferring the Fed would no longer be under pressure to raise rates and in fact could pivot to a more dovish view, then we would expect investors to become less fearful and prone to selling.
That said, there are some initial indications that both inflation and interest rates could be peaking. The following chart shows the headline and core CPIs or inflation rates. The difference between the two is the headline CPI includes gas & food prices, whereas the core CPI excludes them. Food and energy prices tend to be very volatile and can distort the true underlying trend of inflation. It’s for this reason the Fed prefers tracking the more stable core CPI when setting policy. Also, notice in the chart that when the headline CPI greatly deviates away from the core CPI, it typically reverts back to the core CPI.
Currently, the headline CPI is significantly above the core CPI, and both inflation rates appear to be in the process of rolling over.
The next chart shows the 10-year Treasury yield going back to 1998 along with a momentum indicator (stochastic) in the lower inset.
As depicted in the monthly chart, the yellow shaded areas identify periods when the 10-year Treasury yield was “overbought” or significantly extended to the upside. Notice during these times in the past that the 10-year yield didn’t have much farther to go higher and instead typically peaked and reverted, heading down for the next several months or years. With inflation possibly topping and the 10-year yield extended and perhaps readying to turn lower, we could be observing trend changes that eventually allow the Fed to reconsider future rate hikes.
While signs of inflation abating are bullish for markets, we are concerned that perhaps the Fed has already overshot with interest rate hikes, making a recession highly probable in the near future. It’s once again worth repeating what we wrote in the 1Q 2022 investment letter:
An outcome of the Fed raising rates is the economy tends to slow down and even risks entering a recession. The proverbial “soft landing” for the economy is always the Fed’s goal but is almost never achieved. Instead, the Fed is typically “behind the curve” with inflation, meaning it’s arguably late in starting rate hikes and as a result goes too far with the number of rate increases, draining precious liquidity from the financial system and eventually pushing the economy into recession.
The following chart reflects this tendency by the Fed to overshoot with interest rate hikes, eventually having success in breaking the rise of inflation, but at the cost of pushing the economy into a recession.
The chart above shows the yearly change in inflation (CPI) since 1968. When the inflation rate gets above 5% (red line), an eventual final peak in inflation has occurred during recessions (within the grey shaded areas). When annual inflation rises to a level beyond 5%, it conceivably becomes more difficult to combat and tame, requiring the Fed to become quite aggressive with rate hikes. Yet inevitably the Fed’s actions break both inflation and the economy.
Another troubling omen of a future recession is coming from the Treasury yield curve. As we have discussed in past letters, the yield curve has one of the best long-term track records for predicting recessions. When the 10-year Treasury yield falls below the 3-month Treasury yield, the yield curve becomes inverted, a condition that has preceded the last eight US recessions. The following chart shows the 10Y/3M yield curve since 1988 with recessions shaded grey. In the chart, when the blue line descends below the black horizontal line, the yield curve is inverted – as it is currently.
Past performance does not guarantee future results, meaning we may actually avoid entering a recession over the next several months. However, admittedly it’s difficult to argue with an 8-0 record!
Despite these foreboding indications for the economy, there are some bullish points to keep in mind. For one, the current 3.7% unemployment rate – which typically tends to rise before a recession – remains at historic lows. Also, consumer spending, which accounts for nearly 70% of US economic activity, has remained relatively robust so far this year. As for the stock market, historically the worst seasonal period for equities is from May through mid-October, with the 4Q being the best 3-month period for performance. Hopefully this seasonal tailwind will help to counteract or negate any emerging bearish developments over the next few months.
As always, if you have any questions, please feel free to call or email. The entire team at Measured Wealth wishes you all the best during this upcoming holiday season.
Ed Miller, CFA, CMT
Chief Investment Officer
Measured Wealth Private Client Group
Historical data is not a guarantee that any of the events described will occur or that any strategy will be successful. Past performance is not indicative of future results.
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