3rd Quarter 2022 Commentary
WHAT TO EXPECT:
Since this is our first quarterly letter, we thought it would be helpful to start by letting you know what to expect in these notes going forward. And, should you have comments, questions, or suggestions to make the commentary more meaningful, please don’t be shy!
We intend to write regularly about planning, investing, and how the two intersect. Our Modern Investor blog is the best place to read these thoughts, and we intend to publish something there at least once a week. Clients are automatically signed up to receive these updates via email and we will continue to make these available to the public via Divvi’s social media accounts. Please share with family and friends, as they can subscribe on our website.
The quarterly and annual letters will be a bit different, focusing on a few regular topics:
The Facts. Recap of the most relevant events from the previous three months. This is the Market Review section.
Divvi Outlook. Thoughts around the current environment and what we expect moving forward. This is the Outlook section.
In future quarters for discretionary clients invested in Divvi model portfolios, we will also provide some high-level updates portfolios and the rationale for adjustments to the investment models.
Lastly, we write the quarterly and annual updates with clients in mind, so we do not intend to distribute these broadly. That said, if you find the notes helpful and think family or friends would enjoy reading as well, please feel free to share!
With that said, on to our first quarterly commentary…
SUMMARY:
It was a challenging quarter for investors. Stock markets – both in the U.S. and abroad – were lower during the quarter, as were most bond categories.
Inflation and rising interest rates continued to dominate headlines, putting pressure on asset prices. Mortgage rates hit their highest levels in nearly 15 years and weighed on housing affordability.
Going forward, we expect more market volatility as the Federal Reserve continues the fight against inflation. Investors currently expect at least two more rate hikes into the beginning of 2023.
We believe higher interest rates represent a more favorable starting point for many asset classes compared to prior years, but we encourage patience and a long-term view through what could be a challenging path forward for markets.
3rd QUARTER REVIEW
After gaining ground in July, US large cap and small cap stocks retreated in August and September to finish the quarter slightly down.
US markets generally fared better than international counterparts[1]. Emerging market stocks and real estate were particularly weak, losing 11.6% and 10.8% respectively.
September, which we wrote about here, lived up to its reputation as being a crummy month for stocks. US and developed international markets both fell a little more than 9% during the month.
From a sector[2] perspective, consumer discretionary and energy stocks performed best during the quarter, while real estate and communications services sectors delivered poorest returns.
Bonds were weaker during the quarter as well. With recession fears and interest rates both on the rise, losses in fixed income were broad-based. Some market participants had hoped for a less aggressive Federal Reserve in anticipation of economic weakness in 2023. However, Federal Reserve Chairman Jerome Powell reconfirmed the Fed’s commitment to fighting inflation in late-August, paving the way for more interest rate hikes later this year.
Cash and short-term investments attracted more attention with rising yields. While yields on savings accounts remain fairly low, money market funds, Treasury bills and certificates of deposit can often yield between 2% and 4.2%, as of quarter end.
30-year mortgage rates hit 6.7% in September, their highest level since July 2007. Home prices[3] fell for the first time since January 2019, as of July. The National Association of Realtors’ Housing Affordability Index is showing homes have not be this unaffordable since the Global Financial Crisis.
Labor markets remained strong with unemployment rates remaining below 4%. The ratio of unemployed workers to job openings remained near all-time lows, at 0.5, meaning there were two openings for each job seeker.
Inflation continued to dominate headlines. Year-over-year, headline inflation started to moderate in the quarter but remained stubbornly high. Oil prices ended September near $80 per barrel, down about 33% from the June highs. Food and shelter costs continued to push prices higher as well.
OUTLOOK
Overview: For the first time ever, stocks and bonds in the U.S. have both recorded their third consecutive quarter of negative returns[1]. The Fed seems intent on raising rates until something in the economy breaks. Asset prices are leading the way, with stocks, bonds and real estate all reflecting higher rates in the form of lower prices. Employment remains very strong, although we have certainly noticed what seems to be a growing trend of companies announcing layoffs. Still, the unemployment level to job openings ratio remains at record lows. There are two open jobs for every job seeker. Auto sales may finally be showing signs of slowing as well, bringing relief to those who have been putting off car purchases.
The post-2008 Global Financial Crisis monetary policy regime may have shifted. From 2009 through 2021, interest rates consistently trended lower. The Fed purchased bonds at an unprecedented rate, providing further stimulus to the economy. Central banks around the world were generally supportive. “Bad” news would push stock prices HIGHER because investors assumed help was on the way (and they were repeatedly correct). Investors earned nothing on cash and were losing money after accounting for inflation. Interest rates were even NEGATIVE in certain parts of the world.
That environment has shifted. Inflation is hovering near 40-year highs and the Fed is committed to breaking it.
Interest Rates and Inflation: The market expects the Fed to continue raising rates, from the current 3-3.25% target range to 4.5% by early next year, and then trend lower over the next few years. Most forecasts call for inflation pressures to subside in 2023. Gas prices are well off their summer highs, but energy costs in general are still elevated. Wage growth, which had been fairly benign for most of the 2010s, is trending between 5-6%. Headline inflation, which includes food and energy prices, started to roll over earlier this summer as energy prices fell from highs.
Stocks: There are a few drivers of long-run stock returns. Interest rates (think government bonds yields), which are higher and should provide a boost to long-term returns. Dividends are expected to be fairly consistent with past years. Earnings growth is expected to be lower in the near future, but long-term corporate profits typically correlate well with economic growth. Finally, valuation multiples like price-to-earnings ratios for US stocks are still historically above average, especially for time periods characterized by higher inflation and interest rates. Stocks in other parts of the world continue to appear cheaper on a relative basis.
The good news? Today’s starting point may prove to be as favorable for longer-term investors as any in recent memory. We would continue to encourage planned purchases instead of trying to time an exact market bottom. Be prepared for more volatility – it tends to cluster around bear markets and this time is no exception. Global diversification continues to make sense to us with attractive opportunities both inside and outside our borders. Finally, we believe active and passive management both have a place in portfolios and today’s starting point may tilt the scales in favor of high quality active managers.
Bonds: Savers are finally getting a boost by higher short-term rates. We wrote a little more about it here, but higher rates have made holding cash and cash alternatives more enticing. The Fed should continue to influence short-term rates higher, but the longer-term maturities are less likely to move. The yield curve is already inverted, which has often foreshadowed economic weakness. Typically, longer-dated maturities offer higher yields than short-term maturities. When the opposite is true, the yield curve is said to ‘invert.’ And while the Fed has a great deal of influence over short-term rates, longer-term yields are controlled by the market and typically reflect long-run growth expectations.
Considering the likely direction of interest rates and looming recessions, we continue to encourage a diversified approach to fixed income. Shorter maturities should provide a buffer to rising short-term interest rates, but having some exposure to longer-term bonds could prove beneficial if a recession materializes in 2023 and growth expectations fall, bringing interest rates lower. We watch credit spreads, meaning the difference between corporate bond yields and similar US government bond yields, closely at times like this. When those spreads widen, it can potentially present good opportunities for corporate bond investors. It would not surprise us to see those spreads widen a bit more in the coming months, especially if the Fed is successful and our economy experiences weakness next year.
Alternatives: In periods of persistently high inflation, alternative investments can prove very beneficial and offer real diversification benefits. When stock and bond market volatility spikes, prices in many different categories have a tendency to move together. Said more simply, diversification doesn’t work as well in periods of stress. Investments in commodities, trend following strategies, and infrastructure have historically helped in periods like this. We continue to believe these alternative investments can provide value to a portfolio, and having reasonable expectations are important. Abnormally strong performance from commodities and trend-following strategies should not be expected to continue. Diversification benefits are the primary reasons to remain invested.
As always, please don’t hesitate to reach out to the Divvi team with any questions or to schedule time with us to talk more.
Opinions expressed herein are solely those of Divvi Wealth Management and our editorial staff, as of September 30, 2022. The information contained in this material has been derived from sources believed to be reliable but is not guaranteed as to accuracy and completeness and does not purport to be a complete analysis of the materials discussed. All information and ideas should be discussed in detail with your individual adviser prior to implementation.
[1] US stocks represented by the S&P 500 Index. Non-US stocks represented by the MSCI World ex USA Index. Emerging Markets stocks represented by the MSCI Emerging Markets Index.
[2] Using Select Sector SPDR ETFs as proxies.
[3] S&P/Case-Shiller U.S. National Home Price Index
