Every major category of financial-market investment recorded negative returns during the July-September period; for most it was their third consecutive quarterly decline. Domestic large-company stocks gave up around 5%; small-caps fared marginally better, on average. Overseas equities, hammered in local currency, were further slammed by a surging U.S. currency: both developed- and emerging-market benchmarks fell more than 10% in dollar terms. Real-estate securities, too, slid more than 10%, on average. Among commodities, gold was off 8% and industrials down more than 10%, on average; oil skidded nearly 25%. Bond yields soared: the benchmark 10-year Treasury finished at 3.83%, compared to 2.98% at the end of June; credit spreads widened, resulting in a loss of nearly 5% for the broadest bond-market benchmark.
Among U.S. large-company stocks, results within most economic sectors varied widely. On balance, however, the Energy, Financial Services and Technology sectors provided relatively better performance; Communications Services, Consumer Cyclicals and Consumer Staples were weaker. Reversing the pattern of the past two quarters, value-oriented shares underperformed those in the growth category by a substantial margin.
The third calendar quarter of 2022 had something for everyone: pandemic and war, surging inflation and rampant central banks, soaring bond yields and spiking currency volatility – and both soaring and plummeting stock prices.
The Covid pandemic and war in Ukraine continued to provide an unnerving backdrop. Improving immunity and treatment protocols allowed pandemic-related restrictions to be lifted across much of the globe, despite newly soaring infection rates in the Asia-Pacific region and parts of Europe. China maintained its lonely and increasingly quixotic zero-tolerance strategy, with draconian lockdowns plaguing major cities and their industry. And what had seemed settled into a grinding war of attrition morphed suddenly into astonishingly successful Ukrainian counteroffensive, widening the range of plausible near-term outcomes to include both Russian capitulation and tactical nuclear strikes(!).
The U.S. economy continued to slow markedly from 2021’s torrid pace. On the heels of a 1.6% contraction from January to March, aggregate activity (GDP) again declined 0.6% in the April-June period. Though two consecutive quarters of falling GDP are an often-used “rule of thumb” recession definition, the mid-2022 downturn is unlikely to be so labeled by official arbiters, as underlying consumption (so far?) remained consistently positive (weakness was concentrated in inventory destocking, foreign trade and government spending). More timely data signaled a continuation of sluggish-but-not-cratering activity: net job additions averaged nearly 380,000 per month and unemployment claims declined; purchasing-managers surveys indicated manufacturing activity slowed while the services sector accelerated (both indices remained in expansionary territory); and, taking a cue from thirteen weeks of falling gasoline prices, measures of consumer sentiment turned higher, though retail sales were soft. Residential real estate clearly began to show the impact of tightening monetary conditions as mortgage rates reached levels (well above 6%) unseen since 2008; both construction and purchase activity declined.
On the inflation front, a gradual decline in the headline consumer price index (CPI; June: 9.1%; July: 8.5%; August: 8.3%) was accompanied by widespread evidence of diminishing price pressures. Writing just after the (poorly received) August CPI report, research service Capital Economics quipped, “We see disinflation everywhere but in the official CPI statistics.” The list isn’t short: falling prices for gasoline as well as most industrial and agricultural commodities; easing goods shortages (e.g., falling used-car prices); plummeting shipping rates; declining hotel rates and airfares; surveys showing a rapidly declining percentage of businesses contemplating price hikes; both market- and survey-based expectations of future inflation easing into the pre-pandemic range. A high-profile factor that bears separate mention is the cost of “shelter.” Inflation worriers correctly note the surging rents and house prices of the past two-plus years will feed into official inflation measures with a lag, providing continuing upward pressure in coming months. But more timely survey-based information has rolled over, with both house prices and rents recently declining on a month-over-month basis.
Overseas economic activity was mixed but clearly weakening. Pent-up demand unleashed by rapidly receding pandemic-related restrictions boosted second-quarter growth above +3.0% in both the Eurozone and Japan, with the latter registering its fastest expansion since late 2020. Current-period data, especially from the Euro zone and U.K., painted a decidedly dour picture amid skyrocketing energy prices, faltering business confidence and slumping consumer demand; most observers think the continent has entered recession. Whack-a-mole lockdowns caused Chinese GDP to plummet at an annualized rate of -10% between April and June. Snuffing out a nascent early-summer upturn, renewed restrictions, compounded by heat- and drought-induced energy rationing, prompted Beijing officials to begin soft-peddling the official annual growth target (“around 5.5%”); the consensus view of more impartial observers pegs the actual rate closer to 3%.
Roused from their easy chairs by the claxon of surging inflation, the world’s central bankers followed an active spring with a frenetic summer. After more than a decade of ultra-low (and even negative) policy rates, developed-economy central banks collectively raised interest rates 41 times by a total of nearly 2000 basis points (20 percentage points) between the final weeks of 2021 and the end of September. (Bucking the trend, monetary authorities in Japan and China maintained much looser policies; however, emerging-market central bankers outside China chipped in with dozens of additional rate increases). For its part, the U.S. Federal Reserve raised rates five times by a cumulative 300 basis points, including jumbo 75-basis-point (0.75%) hikes at each of its last three meetings. And lest investors doubt their inflation-fighting zeal, Fed bankers also replaced hopeful references to “softish” landings with stern warnings of “economic pain” as they conveyed a newfound conviction that taming inflation will require both a higher peak level (above 4.0%) and a longer duration (beyond 2023) of elevated interest rates.
The global rate-hike tsunami, compounded in late September by the new U.K. government’s ham-fisted “mini-budget,” roiled bond markets to a degree not seen in decades. In the U.S., benchmark two- and ten-year Treasury yields surged 130 and 85 basis points during the quarter, bringing year-to-date increases to 349 and 231 b.p.s; longer-term (20+ year) Treasury investments recorded nine-month losses exceeding 30% – worse than stock-market benchmarks. Volatility spiked to levels comparable to the March 2020 Covid panic and 2008-2009 Global Financial Crisis, and liquidity – the ease of completing large transactions – deteriorated markedly. At peak turmoil on September 28th, the 2-, 10- and 30-year Treasury yields all experienced their biggest one-day drops in 13 years, when the Bank of England stepped in to buy U.K. government debt “at whatever scale is necessary” to calm markets. Outside the normally placid government debt markets, a “buyers’ strike” afflicted the syndicated bank-loan market, causing leveraged buy-out transactions to scramble for financing.
Another casualty of the Fed’s burgeoning rate-hiking zeal were nearly all currencies not featuring the faces of long-deceased American men. During the quarter, the greenback gained more than 7% against a basket of major peers, bringing its year-to-date rise to nearly 17%; the euro, pound sterling, yen and renminbi all fell against the dollar to levels not seen in decades. Though incrementally tamping down U.S. inflation by making imported goods cheaper, the soaring dollar had the opposite impact overseas, raising pressure on foreign central banks to match the Fed’s rate increases (while also acting as an entirely unneeded headwind for U.S. investors in foreign-currency-denominated stocks and bonds).
Already in a deep “correction” after a rough first-half, global stock markets embarked on a third-quarter roller-coaster ride that ended with all gauges firmly in bear-market territory. Having hit an early-year nadir in mid-June, U.S. stocks (S&P 500) surged 17% higher through mid-August, as market participants apparently foresaw a growing likelihood of a salutary Fed “pivot” to a less restrictive policy stance. Nonplussed by insouciant investors who might undermine their inflation-busting project, Fed officials responded with an uber-hawkish PR campaign seemingly aimed at disabusing any and all of the notion that inflation could be slain without pain. The results were impressive: S&P 500 stocks gave back all their gains and then some, falling nearly 20% over the final six weeks and finishing September with a three-month loss of nearly 5%, bringing the year-to-date drubbing to -24%.
Earnings reported by large publicly-traded U.S. companies during the period – mostly covering the April-June quarter – registered a gain of nearly 13% over last year’s figure. For the July-September period, Wall Street analysts expect a year-over-year increase of about 9%, while the full-year tally is pegged to be 12% above 2021’s. Somewhat implausibly, in our view, the consensus projection continues to show a further gain of around 10% in 2023.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the -4.9% S&P 500 total return?
Third Quarter (July - September) 2022
+ Change in Earnings
+ Change in Valuation
= Total Return
Our read: With forward earnings about flat, the market’s ongoing decline continued to whittle away at what began the year as a very challenging (high) valuation measure.
Ongoing pandemic (especially its persistent impact in China), an increasingly fluid and unpredictable situation in Ukraine, and what may be unusually competitive mid-term elections will provide ample diversion in the weeks ahead. Nevertheless, investors seem likely to remain laser-focused on incoming economic data and central banker commentary, as they try to discern whether today’s Fed can avoid its predecessors’ penchant for “hiking rates until something breaks.”
A plausible analysis of the third-quarter market roller-coaster goes like this: following June’s surprise jumbo rate hike, investors seemed to adopt the view that the Fed was on the right path to engineer a “softish” landing, as bond yields eased, stocks rallied, and market-derived inflation expectations declined. But Fed officials, perhaps concerned that rising asset prices engendered by “investor complacency” might at least partially undo their tightening of financial conditions, embarked on a campaign of amplified hawkish rhetoric, beginning in mid-August and culminating with new interest-rate, inflation and growth projections – all surprisingly downbeat – following their late-September policy-setting meeting. The marked shift in tone seems to have convinced many investors the Fed had, as U.C. Berkeley economist J. Bradford Delong put it, “given up” trying to engineer a soft landing and, in effect, “chosen” recession over inflation. (Although its market impact is difficult to gauge, the astonishing turn of events in Ukraine unfolding around the same time also unhelpfully boosted uncertainty surrounding the path that conflict is likely to take in coming months.)
The above narrative suggests investors have lately become much more pessimistic about the economic outlook – or, perhaps more accurately, about the appropriateness of central bank policies given the economic outlook. But we see reason to believe (hope?) that such pessimism could be near its peak. As detailed above and in our July letter, there have been ample indications since late-spring/early-summer that 1) current inflation is decelerating and likely to be falling soon, 2) expectations of future inflation are declining and back in line with pre-pandemic norms, and 3) economic growth in the U.S. has fallen from the overheated pace of 2021 but does not seem to be in anything like free-fall (while both Europe and China face increasingly dire outlooks). In other words, the real economy seems to be behaving much as the Federal Reserve would want if it were to achieve its goal of bringing inflation to heel without inducing a recession. And meanwhile, “things” have begun to “break,” most notably in global currency and bond markets.
Fed officials are aware of these trends – though they might interpret them somewhat differently. They also know that their policy “tools” work with substantial lags – that is, the full effect of the tightening already in place (not to mention additional moves signaled to be in store) will not be felt for some time. Accordingly, we can envision a salutary scenario in which global economies continue to struggle, and/or more things “break” in the financial markets, and the Fed (perhaps joined by other major central banks) responds by beginning to telegraph at least a “mini-pivot” in policy. A subtle change of tack might emphasize that future policy decisions will be “data dependent;” that is, a steady stream of data showing easing inflation and weakening demand (that is, much like we’ve received the past several months!) could result in less restrictive policy than was lately promised. The exuberant market reaction to soft economic reports in the first days of October suggests investors may be beginning to sense something along these lines. Of course, less benign futures can be imagined, too; but we think the degree of investor pessimism apparent around quarter-end adequately discounted some of the more likely ones.
Nine months of market carnage has resulted in major – and in our view salutary – changes to stock valuations and investor sentiment. According to Bloomberg Intelligence, in late September the average stock in the S&P 500 Index changed hands at less than 14 times expected year-ahead earnings – lower than during 2020’s pandemic-driven bear market – and more than 100 index names were priced below 10 times profits. Moreover, nearly three quarters of index constituents were below their pre-pandemic average valuations. (The very largest “mega-cap” names remained historically expensive, however, trading at a 50% premium to the average stock, compared to a historically typical figure of less than 20%.) As for sentiment, the American Association of Individual Investors’ survey found a higher percentage of “bears” than at any time since 2009 (Global Financial Crisis) and 1990 (Iraq’s invasion of Kuwait). Likewise, Bank of America’s survey of institutional investors revealed an all-time high percentage of fund managers underweight stocks (though this series goes back only to 2002). Reasonable valuation and widespread bearishness are both seen by many as necessary – though not necessarily sufficient – prerequisites for establishing a major bear-market low.
In our view, more realistic expectations for 2023 earnings are needed, given the heightened level of macro-economic angst. According to data provider FactSet, a record 240 company presenters mentioned “recession” in their July/August earnings calls. And though Wall Street analysts responded by trimming estimates for coming quarters at the fastest pace since the beginning of the pandemic, they are still, on average, looking for year-over-year gains of around 10%. If the U.S. economy narrowly avoids recession, flat earnings would be heroic; in an actual recession, earnings will likely fall by at least 10% to 15% (the historical average decline is a bit over 20%). Though many investors likely share this view, the process of bringing estimates into alignment looms menacingly over the market.
We have in recent months maintained a moderately less aggressive portfolio stance, anticipating that both the economy and financial markets would struggle with post-pandemic inflation and the transition to a higher interest-rate environment. (As with many investment decisions, hindsight reveals that our instincts were sound but our actions could have been bolder.) Much has changed in the past nine months: yields on high-quality, intermediate-maturity bonds have risen from around 2% to nearly 5%, while stock valuations have fallen from near-all-time highs back toward a more normal level (even if they are not outright cheap). Many stocks we like are priced well below market-average valuation and sport dividend yields between 4% and 6%. As we discussed in our July letter (and more recent intra-quarter update), these changes mean that prospective portfolio returns – that is, what we expect portfolios to earn over the next several years – have increased substantially and the time is approaching to move toward a more fully invested portfolio posture. Buying beaten-down investments amid widespread recession worries and market turmoil is never easy, but it is usually sound long-term strategy.
As always, we encourage you to call or email a member of the Oarsman team any time to discuss our management of your investment portfolio.