2022 Q3 Commentary
While at first glance the third quarter brought more of the same (more inflation, more market declines, more political turmoil), some positive signs of change in these trends have emerged. US GDP is expected to get back into growth territory in the third quarter, and certain highly volatile parts of the inflation index have started to turn around. Last quarter, we wrote about the rising prices of milk and gasoline, and since then we’ve seen milk prices level off and gas prices drop precipitously (in some places, gas is less than $3.00 per gallon).
The markets weren’t looking at the bright side last quarter yet, though. Significant concern remains that the Fed’s efforts to beat inflation by sharply raising rates will end up pushing the US into a recession either later this year or next year. As a result, the S&P 500 declined -5% for the quarter, pushing it to -24% for the year. While by no means historic, this year’s decline has brought the S&P 500 back down below its level at the start of 2021. Bond prices also continued to decline as interest rates rose, and the Bloomberg Aggregate Bond index is down 15% this year through September 30th.
As tough as the markets have been in the U.S. this year, it was worse overseas. The MSCI EAFE index of international stocks declined -27% this year, and inflation has hit 10% in Europe. Near the end of the Q3, the Bank of England had to step in to stabilize their markets by buying long term debt to bring back financial stability. The UK is the only G7 country (which also includes the US, Canada, Italy, France, Japan and Germany) that has a smaller economy now than before COVID, and it is expected to contract again next year.
The US economy remains stronger than international markets, and the Federal Reserve believes that getting inflation under control is still its most important objective. Expect more interest rate increases this year, likely another 1.25%, before the Fed stops to give the economy a chance to catch up. Hopefully the economy will be strong enough to withstand the pressure.
The S&P 500 index started the quarter very hopefully. The index of US large stocks jumped as much as 14% during July and the beginning of August, before falling in late August and September to end the quarter down
-4.9%, which means it has fallen -23.9% year to date. This compares to the 2021 gain of 28.7%. While most asset classes experienced declines again this quarter, small stocks did better than large stocks on the equity side, and shorter-term bonds beat longer term bonds on the fixed income side.
International stock returns fell sharply in the third quarter as the Ukraine conflict dragged on and threatened European energy access. The MSCI EAFE index of international stocks declined -9.4% in the quarter. China’s growth has slowed due to continued zero-Covid policy shutdowns and a housing crisis. For the first time since 1990, China will have slower growth in 2022 than the rest of the Asia-Pacific region (according to the World Bank), weighing down the MSCI Emerging Markets Index which declined -11.7% for the quarter.
The US Federal Reserve has raised interest rates at an unprecedented speed in an effort to choke off inflation this year. Fed Funds have been pushed up by 3% already this year, with 1.5% of that increase in the third quarter. With inflation stubbornly high, the Fed is likely to continue to increase rates at its next several meetings.
Rising rates have hurt the prices of existing bonds with lower rates. The Bloomberg US Aggregate Bond Index declined -4.3% in the third quarter, while the shorter-term (1-3 year) component of this index only fell -1.2%. Global bonds declined -3.2%, as measured by the Bloomberg Global Aggregate Bond Index.
Commodity prices generally fell in the third quarter, with the S&P commodity index losing -10.3%. Brent crude oil prices declined -23% in the third quarter, as concern about falling demand from a slowing global economy overwhelmed continuing supply concerns. Oil prices are now similar to the prices before Russia invaded Ukraine, which has surprised many veteran commodity investors.
Over a year ago, in our commentary for the second quarter of 2021, we wrote that inflation was being under-reported. “Shelter Costs” (i.e. rents/housing costs) have a very significant weight in the inflation measure, and they lag reality by a year or more (because, for example, it takes a while for your annual apartment lease to renew with a price increase). We felt that “core” CPI was definitely going to increase from the 3.8% annual rate being quoted at the time (May 2021 data) and we did not believe talk about inflation being transient. As we suspected, shelter costs caught up eventually, and rising rents, mortgages, and housing costs are now fully reflected in the more recent data.
At this point, shelter costs may start to be an anomaly on the other side, and may be over-estimating actual inflation as they catch up with the other components. If this is true, inflation may have already peaked. The Federal Reserve is still working hard to get inflation back down toward its 2% goal, and we may not be done yet with rate increases just yet, but we may be at the beginning of the end.
If the Fed does overshoot the mark, which is a real concern, we could still suffer a policy-induced recession. Markets tend to anticipate recessions and decline well beforehand, and that trend seems to have held true again in this cycle. The question now becomes whether things will be even worse than the market expected. In that regard, the current low unemployment, continued corporate earnings growth, and moderate household debt levels should help the US economy to buffer any downturn that comes.