Q3 2022 Update

In the third quarter of 2022 investors witnessed another serving of volatility. After sharp drops in Q2, July saw a relief rally into mid-August that highlights our theme of this letter: today’s markets are held short-term captive to the anticipated actions of the Federal Reserve in their battle with inflation.

DataTrek’s Nicholas Colas reminded us in a newsletter of the Fed’s influence, pointing out that even though the S&P 500 is down over 23% year to date, “9 single days make up that entire decline. Without them, in fact, the index would be up 8.6% YTD,” Colas wrote. The bad days, he pointed out, largely occurred on days with bad macroeconomic or Fed-related news — events that are typically scheduled!

In the Federal Reserve’s September policy meeting the Fed raised short-term rates to 3.0-3.25%, from 0-0.25% to start the year; expectations are for at least another 0.75% increase by year-end.

The S&P 500 hit a low on June 16, recovering 17% by August 16 on expectations that inflation had peaked and alleviating fears, temporarily, that the Fed would continue their aggressive rate increases. This optimism was doused with cold water when expected reductions in prices & wages never materialized. The S&P 500 would sink by September 30 to a new low for the year, reminding investors yet again about the dangers of trying to predict the markets.

What about Bonds?

Bonds have not been spared either, with the Barclay’s US Aggregate bond index down 4.75% for the quarter and an eye-opening decline of 14.61% year-to-date. All major indices ended the quarter in bear market territory with the S&P 500, Dow and Nasdaq declining 4.9%, 6.2%, and 3.9%, respectively, from July to September on a total return basis. With the dollar strengthening and the global economy slowing, the MSCI EAFE index of developed markets fell 10% over the same period in dollar terms, while the MSCI EM index of emerging markets pulled back 12.5%. Interest rates jumped with the 10-year Treasury yield climbing above 4% on an intra-day basis, the highest level since 2008. Even energy, a strong performer in the first half of 2022, faltered. The challenges of persistently high inflation and slowing growth have continued to impact the expectations of both investors and policymakers.

While the markets of 2022 can feel unsettling, it’s worth pointing out that the S&P500 is still positive by 46.4% since the beginning of 2019

For a perspective on interest rates it’s worth studying the period between 1976 & 1981. The Federal Reserve board led by Paul Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. The prime rate rose to 21.5% in 1981 as well, which helped lead to the 1980–1982 recession, in which the national unemployment rate rose to over 10%. This action was taken due to the lack of action in the years prior.  Today’s Fed Chairman, Jerome Powell, is attempting to repeat this action long before rates get out of hand, and projections are for peak fed funds rate of 4.5% in early 2023.

Why is good news bad news? (hint: look to the Fed)

If you scratched your head when the markets tumbled this year on good economic news and vice versa you are not alone. As a refresher, the Fed holds a dual mandate from Congress: maximum employment and price stability.  In the response to Covid the Fed lowered interest rates to near zero and pumped a massive amount of money into the economy to keep folks employed and consumers spending. This accomplished maximum employment, but that level of stimulus lasted too long (in our humble opinion) and began to overheat the economy, leading to today’s inflation. Earlier this year the Fed finally began raising rates and reducing liquidity, spooking the markets with fears of a recession. Their goal is a ‘soft landing’ whereby rates return to normal and the economy slows, but does not stall. 

This leads us to the at-times inscrutable logic of the markets: good news can be bad news.  Better than expected employment data implies the Fed needs to keep their foot on the gas raising rates; ditto smaller-than-desired drops in inflation data or other signs the economy is burning too hot. So, the market reacts negatively because they fear the Fed will overdo it and harm the economy. This upside-down world is a short-term, policy-driven construct and, we believe, fails to account for the long-term strength of the economy. As Warren Buffett famously maintains, “Never bet against America”.

Today’s volatility demonstrates the markets looking for a bottom in this cycle. We cannot predict when the bottom will be found, or how deep it will be, but we do know that it WILL be found and the recovery, as with all previous recoveries, will be surprising and probably sudden. Again, staying invested is the key.

As unsettling as the current market values of investments may be, it is critical to highlight the following:

2022 is unusual in that we started the year at the all-time-high point and on September 30 we hit the low point year-to-date, placing high-low pins in the exact reporting calendar dates. The markets have had previous 20% declines intra-year but rarely captured on camera like this year.

Cash flow, or income, produced by your portfolios is stable, and arguably strengthening as rates rise. Remember, rising rates are ultimately good for bond holders since the reward is higher for being a lender.

Default & bankruptcy risk remain extremely low, meaning the market value of stocks and bonds have been punished this year but their fundamentals remain strong enough to weather this downturn. Bonds will mature at par and companies will adapt and grow and find ways to add value to investors in the future.

You should not be losing sleep unless your investment time horizon has changed from ‘your lifetime’ to ‘next month’.

What’s Next?

At this time the equity markets will ebb and flow with the Fed-induced volatility. This is part of being a disciplined long-term investor and is inherent in the journey to long-term growth.

The chart to the right showcases the benefits of a steady hand on the tiller (to quote a sailing & farming term) as for every bear market there is a much more powerful bull market to follow.

We will continue to provide market updates on a quarterly basis. If you have any questions or comments, please feel free to reach out.

The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The market index is unmanaged. Investors cannot directly invest in the above index.
The NASDAQ Composite Index is an unmanaged, market-weighted index of all over the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System.
Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. You cannot directly invest in this index.
The MSCI EAFE Index (Europe, Australasia, Far East) is designed to measure the equity market performance of developed markets outside of the U.S. and Canada.
The Bloomberg US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market.