Hello, clients and friends, and happy autumn to you. Our entire team at Integrity Wealth Advisors hopes that you are enjoying the change of seasons. For those of us that live in Colorado, what a great time of year to be here. The leaves are changing. The morning and evening temperatures are crisp. The sunshine is brilliant. The snow is still distant. As the holidays approach, we look forward to connecting with you and celebrating life. Our annual Christmas Open House will be on December 15th and we hope to see you here.
Despite much to celebrate, the first three quarters of 2022 have turned out to be very challenging for the public markets. We will review the data and unpack what happened in the third quarter.
According to St. Louis Federal Reserve data measuring monthly Standard & Poor’s (S&P 500) performance, September has been the worst month on average for stocks over the past 51 years. This September was indeed a weak month. It was also the worst month for stocks in 2022 (MarketWatch, monthly data). The difficult quarterly and annual performance is fully displayed in Table 1.
Table 1: Key Index Returns
|Asset Class||Index||3rd Quarter 2022||Year-to-Date 2022||Three Years|
|US Stocks||Russell 3000||-4.5%||-24.6%||7.7%||11.4%|
|Foreign Stocks – Developed World||MSCI EAFE||-9.4%||-27.1%||-1.8%||3.7%|
|Foreign Stocks – Emerging Markets||MSCI EM||-11.7%||-27.2%||-2.1%||1.1%|
|US Inv-Grade Taxable Bonds||Bloomberg US Agg. Bond||-4.8%||-14.6%||-3.3%||0.9%|
|US Municipal Bonds||Bloomberg Municipal Bond||-3.5%||-12.1%||-1.9%||1.8%|
|US High Yield Bonds||ICE BofA US High Yield||-4.2%||-15.8%||-1.6%||3.9%|
Data sourced from PIMCO as of 9/30/22.
You and I are well aware of the higher prices we are paying for a range of goods and services. The Federal Reserve has also been grappling with the worst inflation in over 40 years.
High inflation has forced the Fed to react by ratcheting up interest rates at the fastest pace since the early 1980s, according to St. Louis Federal Reserve data. Higher rates have pressured stocks. Because the price of bonds moves in the opposite direction of yields, rising rates have also pressured bond prices for bonds already in a portfolio.
Inflation is not the only issue. The war in Ukraine, wage pressures due to multiple jobs available for every unemployed person, and increasing interest rates all contribute to the witch’s brew.
Increasing Interest Rates
Here is a question that sometimes comes up: “Why is the Fed raising interest rates to tackle inflation?” We can go back in history to gain some perspective.
Inflation raged in the 1970s. In early 1981, the Fed briefly pushed the fed funds rate over 20% (St. Louis Federal Reserve). Six months prior to that, the key rate sat near 10%. When rates soar to seemingly unfathomable levels, economic activity slows amid the soaring cost of money.
This is not the 1970s, but the concept is similar. Raise interest rates, which raises the cost of money and—the Fed hopes—slows demand. Slower demand would likely reduce sky-high job openings (in turn, reducing upward pressure on wages). Slower demand makes it more difficult to raise prices, which would bring down the rate of inflation—at least that is the theory behind the Fed’s reasoning.
An Example from Real Estate
A more recent example may help. Fifteen months ago, the U.S. housing market was at a fever pitch. People listing homes could expect multiple offers, oftentimes bidding wars, the day a home went on the market. While that may sound great if you were selling, it was anything but great if you were moving into a new community needing a home. In short, that type of activity was disruptive for many… and ultimately unsustainable.
What was fueling the hot housing market? Historically low mortgage rates. Cheap rates allowed the monthly mortgage payments (spread over 30 years) to be more accessible to more buyers despite ever-increasing housing prices.
Today, mortgage rates are double or triple what they were 15 months ago. When you raise the cost of money, you slow demand. As a result, those who list a home today can expect it to be on the market longer and the seller may have to negotiate the price down. A word that describes the real estate market today – normal. The current environment is how selling a home has been for many decades. Of course, if rates continue to rise unabated it could bring the housing market to a halt. No one wants that. It is hoped rates and housing prices find a happy medium.
Doves vs Hawks
In July and into August, investors were warming to the possibility of a dovish reversal in Fed rate hikes early next year—a pivot, according to a closely watched gauge that measures rate expectations.
In a short speech [https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm] August 26 that lasted about nine minutes, Powell was direct, calling the Fed’s goal of price stability its “overarching focus right now.”
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance,” he said.
“While higher interest rates, slower [economic] growth and softer labor market conditions will bring down inflation, they will also bring some pain [emphasis added] to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
It is unusual for a Fed chief to use the word ‘pain.’ It was not an off-the-cuff remark; it was carefully selected in a prepared speech. In recent years, rate hikes have been communicated in gentle terms. It is a different economic environment today. The Fed intends to squash the very inflation it helped create.
In the Fed’s view, it is better to take a tough stance now rather than to be forced into even harsher measures down the road. While there was no mention of a recession in Powell’s speech, past talk of a soft or softish economic landing was noticeably absent.
A soft landing is jargon for a slowdown in economic growth that preempts a rise in inflation (or slows the rate of inflation) without a recession. We saw this take place in a series of rate hikes in 1983-84 and 1994. In both cases, economic growth moderated, rate hikes ceased, and stocks posted strong returns in 1985 and 1995.
Third Quarter Recap
In September the Federal Reserve hiked the Fed funds rate another 75 basis points (1 bp = 0.01%) to 3.00% – 3.25%, maintained its aggressive stance, and suggested in its economic projections that we might see another 125 bp increase by year-end (to 4.25% – 4.50%)
While the Federal Reserve is not publicly forecasting a recession, its latest set of projections released last month show it believes its inflation-fighting campaign will boost the unemployment rate next year.
Investors are also growing concerned the economy could sink into a recession next year, which would depress corporate earnings. Jamie Dimon, CEO of JP Morgan Chase, stated, “these are very, very serious things… and they are likely to put the U.S. in some kind of recession six to nine months from now.” (CNBC, 10/10/22)
The sharp increase in interest rates has led to a much stronger dollar. Parking cash safely in the U.S. offers a higher return to foreign investors. A strong dollar reduces the price of imported goods, but the rapid increase in the US dollar against foreign currencies is raising fears the Fed could unintentionally “break” something in the financial markets, at home or abroad.
On October 3, A United Nations agency warned of the risk of a global recession brought on by aggressive monetary policy that may have especially serious consequences for developing countries. “Excessive monetary tightening could usher in a period of stagnation and economic instability” for some countries according to the United Nations Conference on Trade and Development (UNCTAD) in early October 2022.
When Bad News is “Good”
We recognize that the Fed’s steely resolve to bring down inflation has created pain in financial markets. We also recognize that any unexpected shift by the Federal Reserve could alleviate financial market pressures. The kind of international pressure expressed by the United Nations may cause the Fed to take a somewhat less aggressive stance toward inflation going forward.
That brings about a paradox when analyzing financial headlines. We are in an upside-down world where bad economic news may create exuberance in the public markets. Unemployment up. Great! Earnings down. Excellent! Conversely, the public markets react negatively to what may seem to be good headlines like strong corporate earnings. How did we get to such a state?
In short, anything that causes the Fed to pump the breaks on interest rate hikes will be welcome news for the markets. Therefore, if Q3 earnings come in softer than expected or the unemployment rate starts to creep up, don’t be surprised if the stock market rebounds in hopes that the Fed will determine that the higher rates are working, causing the Fed to halt (or at least reduce) the next interest rate increase.
A Silver Lining – a Return to Normal
At the risk of “putting lipstick on a pig”, there are at least a few points of optimism.
The so-called “risk-free” rates offered by short-term (e.g., 1 – 2 year maturity) US Treasuries and certain bank FDIC-insured Certificates of Deposit (CDs) are above 4% for the first time in ages. Fifteen months ago, it was hard to find 0.5% offered by these instruments. That represents a move toward more historically normal rates.
In our earlier real estate example, the recent rise in mortgage rates resulted in a more normal real estate market. Is it painful for some? Certainly. However, for the economy as a whole, the real estate market is moving toward something more sustainable, more normal.
Likewise, the rise in interest rates is causing the public markets to return to something more normal. Fifteen months ago, the forward price to earnings ratio (P/E) for stocks was 1.35 standard deviations above its 25-year average. That was not sustainable for the long-term unless earnings continued to grow aggressively. Today, the P/E ratio has fallen below its 25-year average. Might it continue to fall? Possibly. However, we believe that over time all things will eventually revert to historical norms.
Taking a longer-term view, we want to emphasize that bear markets eventually come to an end, and bottoms typically occur when negative sentiment is high. According to Charles Schwab, the average bull market since the late 1960s ran for about six years, delivering an average cumulative return of over 200% for the S&P 500 Index.
The average bear market lasted roughly 15 months, with an average cumulative loss of 38.4%.
The longest bear market lasted just over two and a half years. It was followed by a nearly five-year bull run. The shortest bear market occurred in 2020 and lasted only 33 days.
A Negative Fixation
Looking back over the past 42 years of S&P 500 performance, two things are immediately clear:
- The number of years the market return ended positive greatly outnumbers the negative return years. It is not close.
- Without prompting, the years I most vividly recall are the negative return years – the 2001 tech bubble, the great recession of 2008, the Covid pandemic correction in 2020. On the other hand, I can hardly distinguish the positive return years.
Apparently, I am much more sensitive to downside than I am to upside. I might conclude that I expect markets to go up, so when they do it does not register nearly to the degree it does when markets go down. It is easy to see that my expectations are suspect… and I do not think I am alone in my need to reshape my expectations. How about you?
A Final Word
Those of us who serve you at Integrity Wealth Advisors are not immune to the volatility of the public markets. Downturns are unpleasant for us. Furthermore, we understand that fear is a real response to heightened volatility. As we have often stated, discipline around asset allocation, rebalancing and sticking to your financial plan is your best strategy especially during times of volatility. Know that we are standing by waiting to speak with you when you need us.
I hope you have found this review to be educational. If you have any questions or would like to discuss any matters, please feel free to give me or any of the Integrity Wealth Advisors team members a call.
As always, we at Integrity Wealth Advisors thank you for the trust, confidence, and the opportunity to serve you. We wish you a wonderful holiday season.