The Third Quarter got off to a a great start in July with a huge rally that extended into mid-August. Stocks escaped the bear market clutches and the Dow, S&P 500, and Russell 2000 cut YTD losses to single digits. It was fueled by what would eventually be seen as an overly optimistic expectation by the market of the Fed ending its inflation fighting, rising interest rate policy plans early, even looking at rate cuts in early 2023.
Those hopes were dashed quickly, when Fed Chair Powell briefly spoke at the annual Jackson Hole Economic Policy Symposium August 26th, reaffirming the Fed’s plans to reduce inflation back to its 2% long-term target, and more importantly quash inflation expectations. The market quickly recalibrated, sending interest rates higher and the stock market rally reversed sharply to end lower in August.
September did its best to uphold its reputation as the worst month of the year for stock returns, with the S&P 500 averaging a scant 0.56% loss historically as noted by CFRA. The September losses were the worst for a month since March 2020, as market sentiment waned and stocks finished the quarter back in bear market territory. While the September returns were rough, the Q3 overall negative returns were more modest given the strong start to the quarter. The S&P 500 fell 9.3% in September, ending Q3 down 5.3%, and closed down 24.8% YTD. The Dow Industrials slid 8.8% in September, losing 6.7% in Q3, to finish down 21% for the year. Rising interest rates continued to hit growth stocks and the tech-heavy Nasdaq the hardest finishing September with a 10.5% loss, and down 4.1% for Q3, to finish down 32.4% YTD. The small-cap Russell 2000 fell 9.7% in September but just 2.5% for Q3, to close the quarter down 25.9% YTD, while the mid-cap S&P 400 lost 9.4% for the month to end down a modest 2.9% for Q3 and -22.5% YTD.
Overseas, central banks are running the same rising interest rate policy as the Fed to deal with high inflation. The European Central Bank and Bank of England both raised interest rates in Q3, as inflation hit double-digits. Developed international stocks fell sharply across the board in September, with the MSCI EAFE falling 9.7% to close Q3 down 10% and –28.9% YTD. Emerging markets lost 11.9% for the month, and 12.5% for Q3, to also finish down 28.9% YTD (MSCI EM). Of note, the international market returns are priced in US dollars, and given the US$'s sharp rise of 17% this year (US$ Index), the non-hedged international returns are more negatively impacted. Priced in local currency, the MSCI EAFE index finished Q3 down a more modest 16.6% YTD, while emerging markets closed down 22.7%.
The Fed raised the federal funds rate 0.75% each at its July and September FOMC meetings, and a cumulative 3.00% for the year. The Fed continues to communicate a strong inflation fighting message for policy guidance to regain and control the narrative, lost last year and in June. The rise in Fed policy rates is deliberate to slow the economy to lower inflation and inflation expectations, as it unwinds its historic Covid-19 pandemic Quantitative Easing monetary support. The message has been heard and clearly reflected in turmoil for both the stock and bond market as interest rates have risen across the yield curve. The risk is that the Fed tightens too much and goes beyond a slowdown into a full recession. And it's being reflected in the markets with every hot economic report, like high inflation in rents, food, and energy, strong jobs/low unemployment near 50-year lows, and healthy consumer demand. Fortunately, some key inflation inputs have been recently rolling over and declining, like the price of oil and gas, other commodity prices, and even rents, along with improvement in supply chain constraints. But further progress needs to be made for the Fed to ease off the brakes.
The degree of difficulty for the Fed to engineer a soft-landing (economic slowdown but no recession) for the economy rose again in Q3. The market is expecting a recession of some degree by the end of 2023, yet the severity remains in question and largely depends if the Fed overtightens policy to fight inflation. Recessions are part of the business and economic cycle, but more importantly so are expansions. In the chart below, Capital Group puts economic recessions and expansions in perspective. While recessions are painful to endure they are typically shorter and more shallow than expansions. Of course, historical data are no guarantee for future results.
The market expects another 1.25% in Fed rate hikes by year end, with the Fed Funds rate hitting 4.25%. That suggests another 0.75% in November and 0.50% in December. The Bloomberg US Aggregate Bond index fell 4.5% in September and 5.0% overall for Q3 to close down 14.6% YTD. The US Aggregate Bond index yield closed Q3 at 4.75%, while the benchmark 10-year Treasury Note yield closed Q3 at 3.83%, up 0.85% for the quarter and up 2.31% for the year. Since 1976, as we noted in the Spring WAA, the Bloomberg US Aggregate Bond index has finished down for the year only four times, with the worst loss being 2.9%.
The Outlook
The end of Q3 was similar to the end of Q2, with steep losses for both stocks and bonds, reflecting a very challenging investment environment, with few hiding places. With double-digit losses year-to-date, bonds have not provided the traditional ballast against stock volatility, which has been frustrating for many investors. While the Q3 losses were not as severe as Q2, they deepened the year-to-date losses for both the stock and bond market, testing investor’s resolve.
As Q4 begins, both stocks and bonds are oversold and reflected in lower prices but more attractive valuations. We are in a peculiar position with the market that currently views good economic news as bad, because it could mean stickier inflation and prolonged Fed rate hike policy. Generally, the market views good economic news and strong corporate earnings as good for stock prices.
There is historical precedent, though no guarantees, that post Mid-Term elections and the third year of a presidential term have been beneficial for stocks. Our partners at Harford Funds provide some valuable commentary on these subjects in our Financial Insights below.
We remain cautiously optimistic the second half of 2022 will indeed be better than the first half. However, that will now depend on a solid Fourth Quarter, which can build momentum for 2023. While repetitive this year, we remain steadfast with our long-term focus in this challenging environment and urge investors to remain disciplined and patient with their investment portfolios.
- Volatility expected to remain elevated in Q4-22 and the foreseeable future
- Keep your focus long-term by maintaining diversification, discipline, and patience
- Refrain from making large portfolio changes
- Maintain regular contributions and a rebalancing program
Call your Nelson Advisor today at 800-345-7593 to discuss any concerns and review your portfolio.
~Your Nelson Securities Team
*Past Performance is No Guarantee for Future Results
