QUARTERLY MARKET UPDATE as of October 2022
After a strong rally during the summer, stocks reversed course and declined again this quarter. The market as measured by the S & P 500 declined 5%, with widespread selling in nearly every sector. Communication services and real estate had the greatest percentage decline, dropping nearly 12%. International stocks in the MSCI Index were off 9%, while small caps in the Russell 2000 Index dropped 2% after a sharp decline the previous quarter.
Bond yields surged across the maturity spectrum with rates hitting the highest levels in over 12 years. The yield on 10-year Treasury notes which reached a peak of 4.0% last month, ended the quarter at 3.8%, up from 3.0% at the start of the quarter. Yields on shorter duration bonds are even higher; 3-year notes are at 4.3%. International bond yields have also reversed course. Several European countries had negative yields last year but are now climbing back to more normalized levels. The United Kingdom 10-year yield climbed above 4% after starting the year near 1%. This was due to both high inflation and confusion over their massive unfunded tax cuts. The British pound has weakened considerably to levels not seen since 1985, trading close to parity against the dollar.
Mixed inflation data and an aggressive policy stance by the Fed continued to concern the market. The Fed’s preferred inflation gauge, the core personal consumption expenditures index (PCE), was up only up 0.1% in August, suggesting that inflation was cooling. That reversed in late September with a higher-than-expected reading and an annual increase of 4.9%. The core consumer price index (CPI) increased 6.3% annually, whereas a separate inflation reading, the most recent producer price index, actually declined 0.1%. The Fed chose to focus on the much higher increases in the CPI and increased the short-term Fed Funds rate by another 0.75% in September. The Fed Funds rate is now at 3%.
Over the decades the Fed has often been slow to react to economic conditions, continuing to raise rates when the economy is slowing, and waiting too long to lower rates when a recession hits. Recent hawkish speeches by the Fed indicate they expect to continue raising short term rates up to 4.5% by next year. While growth as measured by GDP is anemic, the anomaly of a strong market for jobs persists. Unemployment remains at a low historical level of 3.7%. Jobless claims are at five-month lows, indicating rate increases so far are not hurting the labor market. There is still a shortage of workers to fill job openings.
Fed projections have the economy growing 1.2% next year, and unemployment increasing to 4.4% from the current 3.7% rate. Leading economic indicators such as manufacturing activity, building permits, retail sales, the stock market, and changes in GDP, have all declined and are pointing to a weakening economy ahead. We expect that will be reflected in future inflation reports showing inflation is trending downward.
Bond yields may have peaked. While the Fed may continue raising short term rates, we believe the intermediate and long end of the yield curve will reach its peak this quarter. Inflation may still be higher than the Fed’s target ceiling of 2%, but as the economy slows, the risk next year may be more deflationary. The bond market is already anticipating this with longer term bond yields remaining below shorter-term bonds.
We expect supply side shortages due to the economic reopening will be behind us. The excess stimulus that drove demand over the last two years has already worked its way through the system. As well, population demographics have changed compared to decades past and continue to support a slower economy. The lack of population growth is a long-term driving factor that will not sustain higher inflation.
The strength of the dollar will not help corporate earnings, since that makes it more difficult for U.S. multinationals to compete globally. The Euro moved to below parity against the dollar for the first time in twenty years, and currencies in Asian countries have also weakened considerably. This is causing inflation to be even higher globally, and should drive central bankers to raise their interest rates both to combat inflation, and also to keep their currencies from continuing to weaken relative to the dollar.
Residential real estate, which has held up better than most asset classes, is starting to cool. A natural correction is to be expected after a period of rapid increases, but the big jump up in mortgage rates are also having an impact. 30-year mortgage rates hit 7% last month, which makes many purchases unaffordable and is a weight on home prices.
The slowdown we are expecting will drive a shift in fixed income away from cash and short-term bonds towards longer duration intermediate term bonds. We expect interest rates will decline somewhat in 2023 and there are opportunities now to pick up yield and income that was hard to obtain the last few years.
Stock market valuations reflect the higher inflation data. P/E ratios are now back to where they were in 2014. However, the risk in higher valuation growth stocks that do not pay dividends is still higher than the overall market. We will continue to emphasize investments in quality, dividend paying stocks that we expect to outperform.