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Quarterly Commentary – September 2022

The third quarter of 2022 saw equity markets initially turn around to climb higher until mid-August only to resume their slide downward to match the low of mid-June.  The equity market has resumed being in the bear market territory after briefly coming out of it for a month and a half and bringing the year-to-date to annual lows. 

The following are performance numbers from various popular indexes. Please remember index numbers are not individually comparable to a properly diversified portfolio. Each portfolio may include an allocation of securities similar to these indexes in varying amounts based on your personal risk tolerance and should only be compared in that context. Year to date for 2022, the S&P 500 was down 23.9%. The Dow Jones Industrial Average was down 19.7%. The Nasdaq Composite Index was down 32.0%. The Russell 2000 Index was down 25.1%. International equities as represented by the MSCI AC World Ex U.S. Index were down 26.8%. The MSCI Emerging Markets Index was down 27.2%. Fixed Income as represented by the Bloomberg Barclays Aggregate Bond Index ended down 14.4% year to date.

The attention has been on the Federal Reserve which raised its policy rate by 75 basis points for the third straight meeting, bringing it close to its target of 3.00% to 3.25%.  There will be more to come, and the Fed’s own forecast calls for a 4.25% – 4.50% range by December and incrementally higher levels in 2023.  Inflation has been running at its highest levels since the 1980s and has become the primary focus. The Fed’s mandate of maintaining price stability amidst persistently sticky inflation has pushed an aggressive agenda of tightening rates and a hawkish stance that is committed to doing whatever it takes to bring inflation down.  Doing so even at the cost of higher unemployment, slowing down the economy, and causing a recession.  The inflation during the first half of the year was sparked in large part by rising energy costs and supply-chain disruptions from the pandemic.  As economies reopened from the lockdowns, the supply of goods could not meet the pent-up demand of consumers, leading to price increases.  Then as energy prices eased, wages and housing became the primary drivers of inflation.  In trying to slow down the economy, the Fed has run into a significant obstacle: U.S. consumers have not reduced their spending from 2021 when the stimulus money was a factor.  The spending continued to persist despite the inflation.  Households still have significant excess savings and relatively low debt service costs from the all-time low of prior interest rates and having paid down some debt during the pandemic.  Fuel prices which then fell continued to support consumer spending.  The Fed is hoping to strike at consumer confidence by softening the labor market even hailing a closer to 4.5 – 5.0% unemployment rate as a desired effect. With a high level of job-related confidence in a tight labor market, consumers are still apt to spend knowing that jobs are plentiful, and they are in demand. Therefore, keeping close attention to the monthly job reports and the trend in unemployment claims should offer some cues over the next few months as to the progress being made with the Fed’s policy tightening.  

In the more interest-sensitive sectors such as the housing market, the rise in mortgage rates has put a damper on demand. With the run-up in home prices and rising mortgage rates which have doubled this year, home affordability has taken a hit and home sales slipped for six consecutive months since February. The demand picture and pricing have started to ease, however with the limited supply of housing still at historic lows, pricing should stay relatively elevated, also contributing to inflationary pressures. With higher rates, homeowners will be discouraged from selling properties that were financed at much lower rates, further exacerbating the inventory shortage in housing.  One positive relative to the prior bubble are the improved credit conditions with mortgage debt service relative to disposable income at low levels on a historical basis. Also, the lessons learned from the global financial crisis with the use of more sound lending practices should limit the risks of a widespread market collapse and contagion into the economy.  With rates rising and expected to continue to do so, there will continue to be a direct impact on the economy and asset prices.

Thus far, earning estimates for stocks for this year and next have been surprisingly durable with relatively few downward adjustments and that is a positive.  

Although the probability of a recession is now higher than it was a few months ago, it is likely to be mild. This in part because there are no excesses such as a housing or dot.com bubble. Second, the current level of job openings will reduce the chance of significant layoffs, particularly with total employment below pre-pandemic levels. Then, despite the rhetoric of the Fed, will there be a willingness to accept a slightly higher inflation target over the infliction of too much pain on the economy.  In other words, at what point does the medicine become worse than the cure?  There is fear that the Fed which has admittedly been wrong when it perceived inflationary pressures as transitory last year and failed to act, and is possibly overdoing it now to regain credibility. Yes, inflation is bad and once it sets into the psyche of consumers, it can lead to inflation spiraling upwards as consumers bring forward their consumption with the assumption that goods and services are cheaper today and will be more expensive in the future.  This would create added current demand which would exacerbate further the imbalance between supply and demand making inflation worse.  This explains the urgency of the Fed at the risk of overdoing it, which historically is more often the case than not. Then, some will argue that we have already entered a mild recession, an unusual one given the high level of employment. We will only know for certain after the fact. 

The equity markets are most definitely in a downtrend. As Bear Markets go, we are in the 12th longest on record since 1974 of which there have been 28. In comparison, it is mild, ranking 5th in the lowest magnitude.  Regardless, it is important to note that equity markets are forward-looking. A lot of what is known has been factored in already as well as what market participants expect. The forward paths of inflation, economic growth, interest rates, earnings, and valuations are in a state of flux that is higher than usual.  We are at risk of further declines depending on how things play out, however it is also important to remember that there is the possibility of some better-than-expected news turning the ship around quickly. A catalyst such as inflation getting under control sooner or improvements on the geo-political scene could cause a forceful bounce, particularly as we are now in what is very oversold territory.   With the upward bias of the equity markets over time, the risks of missing out on such bounces are a significant consideration.  It is detrimental to the long-term success of investing, making it such that the best course of action remains to stay the course.  

Headlines are always scary and there is plenty to worry about, but this has always been the case and it will always be. Looking at the long-term view is the only way investing works well. One can argue that we were due for the hangover after extended periods of easy money and extra pandemic stimulus.    Certainly, however we don’t know what the alternative might have looked like.  With higher rates, investors now have the ability to earn income on the fixed income portion of their portfolio with a positive real rate of return, which hasn’t been the case in a long time.

Rewards come with some element of risk.  The risk premium is now more elevated. In other words, investors should get the excess return to compensate for being subjected to an increased level of risk, which is what happens in a more uncertain environment.  Let’s keep in mind that part of the reason we are in the predicament that we are in is that we came out of a once-in-a-century black swan event and managed to be relatively ok, with the market doing well and the dynamics of our economy remaining strong enough to create inflationary pressures. It seems that we’ve been in a lot worse situations before. 

Thank you for allowing us to serve you and we hope that you have a wonderful Fall!