As we welcome fall and the cooler weather it brings, we are also continuing to experience a cooling economy. The good news is that there is no official ruling that we have entered into a recession. What we are mindful of, is that there is continued uncertainty which is fueled in part, by rising interest rates, unrest in the Ukraine and now Japan, and a historically high Consumer Price Index. On a positive note, the jobs market is still strong, which could help the successful taming of inflation.
Below you will find a look back on market and economic activities throughout the third quarter of 2022 from our team of experts. For additional in-depth analysis, you may view recordings of our team as they share insights on various local and national media outlets, as well as our weekly The Markets and the Economy email series at www.RocklandTrust.com/Wealth&Investments.U.S. gross domestic product (GDP) fell into negative territory in the first half of 2022. Real GDP estimates showed that the economy contracted at a 0.6% annual rate in the second quarter of 2022, following a decline of 1.6% in the first quarter. The decline in first quarter GDP was in part exacerbated by the Omicron variant, but the drop in second quarter GDP was largely driven by reductions in retail trade, construction, capital spending on equipment, inventory investment, and federal, state, and local government spending. This was partially offset by increases in exports and modest gains in consumer spending. Given the backdrop of lower fiscal spending, a significant increase in the value of the U.S. dollar, and 30-year mortgage rates that are approaching nearly 7%, there is a strong case to be made that GDP growth could remain soft in the second half of 2022.
The Conference Board, a well-known non-profit business membership and research group that provides economic forecasts, recently published a memo indicating that they expect economic weakness to intensify in the second half of 2022. They do not believe the U.S. is currently in a recession due to strength in a number of sectors and a very tight labor market. They do however, expect that a broader downturn is underway as a result of stubborn inflation which has led the Federal Reserve (Fed) to remain committed to raising the federal funds rate. Rising interest rates increase borrowing costs, encourage saving over spending, reduce demand for goods and services, and in theory should help to rein in inflation.
Inflation has begun to dampen, but still remains high and continues to surpass expectations to the upside. The headline Consumer Price Index (CPI) fell from 8.5% year-over-year in July to 8.3% year-over-year in August, but remains at a very high historical level. Declines in energy prices helped drive a modest decline in this number, offset by growth in categories such as food, rent, medical care, home furnishings, and new vehicles.
On a positive note, the August jobs report indicated that the labor market remains very robust. We continue to see momentum in employment gains with nonfarm payrolls growing by 315,000, bringing total employment above pre-pandemic levels. The strength in the job market attracted 786,000 people to re-enter the workforce as average hourly earnings continue to set new all-time highs. The increase in total labor supply led the unemployment rate to tick up to 3.7% from 3.5%, however this is still extraordinarily low by historical standards.
Second quarter corporate earnings season resulted in 70% of companies surpassing earnings estimates and 63% exceeding revenue expectations. Revenue beats are tracking slightly above their long-term average, while earnings beats are tracking below. Common themes are record inflation levels, supply chain constraints, inventory challenges, and a strong U.S. dollar. Looking ahead to third quarter earnings estimates, Factset reports that the estimated growth rate of S&P 500 earnings is 2.9%, which would be the lowest growth rate reported by the index since the third quarter of 2020. Given the economic weakness we experienced the first half of the year, analysts have reduced third quarter 2022 earnings estimates by 6.6%, a level well above historical averages.
The market continues to contemplate whether the Federal Reserve actions will result in a soft or a hard landing for the economy. A soft landing could entail the successful taming of inflation through increasing the federal funds rate at a pace which decelerates economic growth while maintaining full employment. Conversely, a hard landing could entail the Federal Reserve overtightening rates and pushing the economy into an economic recession. We have continued to see this impact with S&P 500 earnings forecasts steadily declining, both as a result of economic slowdown and a stronger dollar. While we do not have a crystal ball to know which direction we will ultimately head, we do know that the uncertainty has contributed to volatility in markets and has caused both stocks and bonds to fall. As bond prices have fallen, yields have risen and now offer investors more protection against a market correction or downturn. Similarly, the stock market is now discounting future cash flows of companies at higher rates causing stock valuations to fall, resulting in some attractive investment opportunities, which we continue to evaluate.
| Asset Class | Benchmark | Q3 |
|---|---|---|
| US Stocks | S&P 500 | (4.88%) |
| US Gov't Bonds | Bloomberg US Govt Intermediate | (3.05%) |
| Cash | Bloomberg US Treasury Bill 1-3 Mon | 0.47% |
It has been a volatile year for the S&P 500. In the third quarter, the index was up nearly 14% at one point only to recede to a fresh low. That is the fourth time this year we have seen the market rally by more than 6% only to reverse course to a low. Following a roughly 20% decline in the first half of the year, the index fell nearly 5% in the third quarter to bring the total year-to-date decline to 23.87%.
The Federal Reserve’s increasing hawkishness around monetary policy, aimed to tame persistent inflation, caused U.S. Treasury yields to rise to their highest levels since 2008, with the 10 year Treasury note briefly touching 4%. This contributed to equity valuations continuing to fall, as future cash flows are discounted back at higher rates. The U.S. dollar has also risen significantly and was up 7% in the quarter against a basket of global currencies, the highest level since May 2002. This has caused countries like Japan and the U.K. to take action to shore up their currencies, causing global yields to rise. One way a higher dollar impacts U.S. multinational companies is that it increases the costs of their goods/services relative to local competitors. Lastly, while supply chain challenges are broadly improving as economies have re-opened, there are a number of companies still reporting supply chain and inventory challenges which are weighing on their stock prices even if they beat expectations.
Nine out of eleven of the S&P 500 GICS sectors posted negative returns in the quarter. The Consumer Discretionary (+4.36%) and Energy (+2.35%) sectors both finished in positive territory, while the Real Estate (-11.03%) and Communications (-12.72%) sectors faced double-digit declines.
From a style standpoint, growth stocks (Russell 1000 Growth -3.60%) outperformed value stocks (Russell 1000 Value -5.62%), however growth stocks are still down over 30% for the year and are on pace to have their worst year since 2008. Growth stocks are generally more sensitive to moves in interest rates as their future cash flows are generally less certain and further out into the future.
From a factor standpoint, low volatility stocks (MSCI USA Barra Low Volatility -9.34%) significantly underperformed momentum stocks (MSCI USA Barra Momentum +0.53%), however low volatility stocks and companies with low leverage have been safe havens this year as interest rates have risen and market volatility has increased. Our bias towards these types of companies has aided our relative outperformance in the downturn.
From a market capitalization standpoint, Small Cap stocks (Russell 2000 -2.19%) outperformed Large/Mid Cap Stocks (Russell 1000 -4.61%) in the quarter, however both are down roughly 25% for the year.
Investors pay particularly close attention to the U.S. Treasury 10-year yield as it sets the floor for borrowing costs across the economy including mortgage rates. The yield on the 10-year Treasury finished the quarter at 3.83% versus the start of the year at 1.51%, increasing 232 basis points. During the quarter we saw both the 10-year U.S. Treasury and the 2-year U.S. Treasury yielding above 4% with the 2-year Treasury ending the quarter at 4.28% or 45 basis points (0.45%) higher than the much longer 10-year Treasury. The inverted Treasury yield curve created further market angst over a potential or pending recession. Central banks such as the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) took emergency steps to boost their economies and currencies which has increased rates throughout the developed markets.
With no safe haven in fixed income both quarter and year-to-date, we continue to see negative returns across all sectors. Indeed, bond investors have experienced the worst Treasury bond market returns in four decades. Credit spreads typically widen relative to lower risk government bonds in volatile periods. Although we have seen slight widening, U.S. corporation balance sheets continue to be strong and they are viewed as financially healthy. For the quarter, the corporate high yield sector was the strongest performer.
While investors attempt to determine if the economy can remain strong amid one of the most aggressive Federal Reserve rate hiking cycles in decades, we continue to remind investors that while initially painful in the form of negative returns; rising rates will help portfolios and build income over time and compound interest at these higher rates. We should look at this as an opportunity to earn yield in our fixed income investments after years of historically low interest rates.
Diversifying equity asset class performance was a mixed bag in the quarter, but has been beneficial year-to-date. Asset classes with higher correlations to interest rates, inflation, and volatility have provided protection in the downturn. Managed Futures and Master Limited Partnerships have outperformed the S&P 500 both in the quarter and year-to-date.
Diversifying fixed income asset class performance was also mixed in the quarter and a headwind year-to-date. Riskier assets classes with higher correlations to credit and equity markets, such as High Yield bonds and Convertible bonds, did well in the quarter but have underperformed the Bloomberg Intermediate Government/Credit Index year-to-date as investors flocked to safer assets.
| Asset Class | Benchmark | Q3 |
|---|---|---|
|
Foreign Stocks |
MSCI EAFE NR |
(9.36%) |
|
Emerging Markets Stocks |
MSCI Emerging Markets |
(11.57%) |
|
US Mid Cap Stocks |
Russell Mid-Cap |
(3.44%) |
|
US Small Cap Stocks |
Russell 2000 |
(2.19%) |
|
REITs |
MSCI US REIT |
(9.96%) |
|
Commodities |
Bloomberg Commodity |
(4.11%) |
|
MLPs |
Alerian MLP |
8.05% |
|
Managed Futures |
Credit Suisse Mgd Futures Liquid TR |
8.06% |
|
Foreign Bonds |
FTSE WGBI Non-USD |
(9.95%) |
|
Emerging Market Bonds |
JPM EMBI Global |
(4.20%) |
|
US Inflation Protected Bonds |
Bloomberg US Treasury Tips |
(5.14%) |
|
Floating Rate Loans |
Credit Suisse Leveraged Loan |
1.19% |
|
US High Yield Bonds |
Bloomberg US Corp High Yield |
(0.65%) |
|
Convertible Bonds |
ICE BofAML Convertible Bonds |
0.29% |
As always, should you find yourself questioning your current situation, our team is always here to help you weather these challenging times. Thank you.
Sincerely,
David B. Smith, CFA
Managing Director and Chief Investment Officer
