The third quarter of 2022 has brought little reprieve since our last writing. The S&P is down -23.9% YTD and the Nasdaq is down -32% YTD. Bonds haven’t fared much better with the Barclay’s Aggregate down -14.6% YTD. The Federal Reserve continues an aggressive pace of rate increases, yet inflation remains stubbornly high. The market reacted negatively in September when higher-than-expected inflation numbers came in, and though employment numbers have begun to creep down, data shows the Fed will need to continue tightening.
The news outside of the US is even less rosy. Europe faces a winter of high energy prices and fears of shortages. Russia continues to weaponize Europe’s oil dependency and cut off supply. As of October 5, OPEC piled on by voting to cut oil production by 2 million barrels per day, compounding the problem globally. A strong US dollar hasn’t helped with inflation outside the US, adding to price pains in other countries.
As we drag into the final quarter of 2022, it’s helpful to put the Fed’s quantitative tightening (QT) into perspective. True, this year has been draining for markets, but take a step back and consider the past decade. Including this year’s drawdown, the S&P 500 is up approximately 12% annually over 10 years. Central banks around the world have been suppressing interest rates for almost 13 years, creating trillions of dollars of negative-yielding sovereign debt, and providing cheap money for businesses and consumers alike. Then COVID all but halted production and snarled supply chains, throwing the world into uncharted territory. Now inflation has barged back into the spotlight after more than a decade. With the benefit of hindsight, we know the Fed was too slow to respond to inflation. Now they’re raising rates at 75 basis points per meeting and reducing their bond holdings. Any QT is a headwind for equity markets, and this is the most aggressive markets have seen since 1994 (the last 75 bpt increase was November 15, 1994). The goal of the Fed’s QT is to slow down inflation without causing a recession. They’re focused on still strong employment numbers: true US job openings registered their second largest monthly decline (-1.1 MM) on record in August (The largest was April 2020 during COVID lockdowns). However, there were still 4 million more job openings than unemployed workers in August. This latest JOLTS report shows employers took a step back in terms of hiring intentions, but we will have to wait for the revised number next month to be sure. The Fed sees the difference between job openings and unemployed workers as driving wage inflation, thus they remain hawkish.
Rising interest rates put pressure on businesses and consumers by making spending more expensive and saving more lucrative. It’s already working with housing: there are 14% fewer new listings coming onto the market now compared to this time last year, according to Redfin data. Mortgage rates are over 6.5%, more than double what they were in 2021. Car loans are also declining as rates tick up and more buyers become priced out. Consumer spending was basically flat in July, down from a 1% increase in June. Manufacturing orders are slowing as businesses respond to reduced demand. As of the end of Q3, the odds are still strong that we’ll see another 75 bp rate hike in November and a 50 bp hike in December. Perhaps it’s helpful the next Fed meeting is not until November 2nd, so markets have October to focus on earnings rather than monetary policy.
One question that naturally arises after an almost 25% drawdown: are markets bottoming? Are equities cheap? Unfortunately, US equities are no steal. As noted above, years of quantitative easing by the Fed have propped up prices and even after this year’s decline, the PE ratio of the S&P 500 is near 19%. Historically, an average PE ratio is closer to 16% and in past bear market bottoms, multiples have been even lower. While we’d love to see an end to market downturn, the numbers are not supportive. But none of that implies we recommend decreasing equity exposure. Instead, we believe current market conditions call for discipline and composure. In our portfolios, we’ve shifted to quality in equity and bonds, focusing on strong profit margins, high cash flow, low volatility, positive earnings, and short duration. We’ve rebalanced portfolios to maintain strategic long-term allocations and harvested losses to lower tax liabilities.
Remember, bear markets don’t last forever. Historically, the average bear market lasted roughly 15 months, delivering an average total loss of 38.4%. However, the average bull market lasts for about six years, with an average total return of over 200%. The longest bear market was just over two and a half years but was followed by a nearly five-year bull run. This is why we continue to believe that personal equity exposure should not change regardless of bull or bear market. We know prolonged market volatility is stressful, and we’re here to help you navigate your personalized investment path.
Heather A. Voight, AIF® | Portfolio Manager
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