The volatility experienced in the first half of the year continued in the third quarter. Most asset classes rebounded strongly to start the quarter on indications that inflation may be topping and inklings that central banks may relent their tightening cycles sooner-than-expected. Subsequent inflation data, however, forced the hand of the Federal Reserve to continue tightening and led Jerome Powell to concretely state that the bank will not stop until inflation is under control despite the economic pain endured as a result. Continuing geopolitical issues, a stronger US dollar, and idiosyncratic global market disruptions added to the uncertainty and drove returns negative across most markets
Q3 2022 Market Commentary
Domestic equities performance in the third quarter was a tale of two halves. Deeply oversold levels entering the quarter quickly led to a large rally for stocks throughout July as hopes for a softer landing and Fed pivot grew.
That sentiment quickly shifted and prospects that further interest rate rises would be modest abated after Fed Chair Powell spoke at Jackson Hole. The chair indicated that the US central bank would need to keep monetary policy tight “for some time” to fight elevated inflation and that “the historical record cautions strongly against prematurely loosening policy”. He added that this tighter policy would slow the economy enough to cause “some pain” for households and businesses as well as the labor market. In addition to the stronger rhetoric, markets began to embed worries that earnings estimates would begin to be cut. The Fed is still between a rock and a hard place as chances of a “soft landing” fade. The central bank is trying to strike a balance between reducing record-high inflation and triggering a major recession in the economy as they raise interest rates. As we have said in the past, this is an enormously challenging task given the historical record. Inflation is up 8.3% year-over-year, and the labor market is very robust.
Many investors are attempting to price in where the terminal policy rate will peak which should provide clues as to when equities ultimately begin putting in a bottom. Until then, volatility will likely remain elevated with large rallies and sell offs dominating headlines. Growth outperformed value this quarter although value is still the relative outperformer year-to-date by the largest margin since the early 2000s. At the index level, the Dow Jones Industrial Average fell 6.2%, the tech-heavy Nasdaq was down 3.9%, while the S&P 500 slid 4.9%. Beneath the surface, Consumer Discretionary (+3.9%), Energy (+1.6%) were the only sectors in the green. The worst performing sectors were Real Estate (-11.1%) and Communications (-11.7%).
Foreign markets underperformed their US counterparts as the MSCI ACWI ex US declined 10.1%.
Equities in the eurozone fell across the board due to similar problems facing many developed nations on the interest rate front. Like the US, the Eurozone is still concerned with how much higher interest rates will affect the economy. Compounding the issue was the brewing energy crisis over supply and high costs amid the Russia-Ukraine war. The inflation rate hit double digits on the last read, accelerating from 8.6% YoY in the second quarter. Earlier in September, Russia turned off the taps on its main natural gas pipeline to Europe and according to Eurostat, household energy prices soared to 40.8% higher in September than a year earlier. This all comes at the same time the European Central bank raised rates 75 basis points, bringing its benchmark deposit rate to 0.75% - the ECB has had negative rates since 2014. They have signaled more rate rises will be announced at is upcoming policy meetings. Most economic data, including a new all-time low in consumer confidence, points to a continued slowdown and recession in the region this year.
Across the pond, UK equities fell 12% during the third quarter. Larger cap names in the energy and consumer defensive sectors held up better relative to consumer-focused areas amid fears of rising energy prices and interest rates, in line with the trend this year. During the quarter, the Bank of England delivered its second consecutive half-point rate hike, moving the policy rate to 2.25%. At the time, the BoE was under enormous pressure to keep up with other global central banks to protect the pound, which slumped to its lowest level since 1985. Inflation remains in the double digits. Most of the eye-catching headlines and volatility in the UK occurred towards the end of the quarter when the new conservative government of Liz Truss announced a spending deal to stimulate the economy, which included sweeping tax cuts. The thought of this package adding to already high inflationary pressures entered market participants thoughts. In the days following the announcement, spikes in yields, a selloff in currency markets, and fall in equities caused the BoE to begin a temporary purchase program to calm volatility. The government and Finance Minister later scrapped plans to cut taxes on the country’s highest earners, a major U-turn, hoping to add stability to chaotic market action.
In Japan, the Bank bucked the global rate hike trend by maintaining ultra-low interest rates at 0.1%. Their guidance pledged to keep monetary policy ultra-loose until inflation stably achieved the 2% target. Yet, inflation in the region hit nearly 3%, exceeding the 2% target for a fifth straight month. Price pressures from materials and a weaker yen broadened. At the meeting, one member pointed to concerns among some investors that distortions in bond market functioning given the BoJ’s large bond buying program. Japan’s Ministry of Finance, in order to fend off further weakening, intervened to support the yen for the first time since 1998. The move was met with limited success. The iShares MSCI Japan Index fell 0.9% for the quarter.
Emerging markets underperformed domestic and foreign developed markets as the index slid over 11%. A surging dollar, which weighs on many EM countries with dollar denominated debt, exacerbated the fall. China is the largest weight in the index and was confronted with many headwinds for the quarter. The economy remains delicate given their zero-covid policy, weakness in the housing market, and tempering global demand. Inflation is low compared to the rest of the world at 2.75% which allowed the People’s bank of China to ease monetary policy slightly during the quarter. One move involved reducing the threshold of foreign reserves banks need to hold, theoretically reducing the weakening pressures on the yuan versus the dollar which has fallen to lows not seen since 2008. Turkey, despite having inflation over 80%, was the best performing market as their central bank cut rates twice. India, Indonesia, and Brazil were also outperformed as growth and inflation improved.
Despite typically serving as a ballast during turbulent equity markets, fixed income’s performance in the third quarter was eerily similar to the equity story. The first half of the quarter witnessed bonds rally strongly off their June lows due to optimism that inflation’s high-flying run was over, and that the Federal Reserve would pivot sooner than expected. These hopes were dashed by subsequent inflation prints, the Fed’s aggressive elevation of its policy rate, and Jerome Powell’s hawkish remarks in appearances that followed, reinstating the bond bear market. The drastically elevated level and persistence of expected interest rates drove yields higher across the board, forcing bond values lower. The Bloomberg U.S. Aggregate Index lost 6.9% in the quarter.
The overall U.S. Treasury market fell sharply, down 4.7%, to end the quarter due to Fed action and the path of expected interest rates. The shorter maturity bonds, whose yields are primarily driven by Fed policy, saw their rates rise relatively more than longer term treasuries, which have been dampened by a softening economic outlook. This dynamic forced the yield curve to transition from roughly flat to start the quarter to deeply inverted by the end of September. Inverted yield curves typically appear ahead of recessions.
The corporate bond market performed in a more resilient fashion than treasuries, but the negative returns were dispersed unevenly across the universe. Investment grade bonds, which are issued by high credit rated borrowers, were down 7%, sharply underperforming the riskier high-yield segment which returned -0.7%. Investment grade bonds are more sensitive to interest rate movements than high-yield as the latter is more intricately linked to economic health. Soaring rates in the third quarter led to a rout in the investment-grade market. A flat but stable economic backdrop helped high-yield remain relatively stable.
Data indicating a global slowdown in economic activity, and therefore lower demand for fuel, forced a rout in the oil market with WTI Crude finishing the third quarter down 21%. While supply issues due to the war in Ukraine and other factors leading to tight inventories, these constraints have loosened over the past few months. The strength of the US Dollar and the increase in yields relative to inflation combined to drag on the performance of Gold (-7.5%) and Silver (-6.5%) which typically act as safe havens in times of high inflation. Industrial metals ranging from aluminum, copper, and nickel were broadly lower. Agricultural commodities were roughly flat over the quarter.