Third Quarter 2022 Market Update
November 9, 2022
We’re currently in the throes of the fastest tightening cycle in at least 40 years. This is unlikely to happen without a couple fender benders in the economy, but hopefully we can avoid a multi-car pileup. – Domestic Equity Manager
Third Quarter 2022 Market Update
The third quarter of 2022 brought about continued volatility in capital markets, including broad-based and sharp price declines across most traditional asset classes. Investors found very few places to hide as persistent inflation caused central banks, particularly the U.S. Federal Reserve (the “Fed”), to tighten monetary policy by aggressively raising benchmark interest rates. Nearly all asset classes posted losses, as tighter financial conditions continued to weigh on markets. Markets saw some relief early in the quarter as inflation appeared to be peaking, however, subsequent inflation surprises to the upside, continued signs of slowing economic growth, declining consumer confidence, and downward corporate earnings revisions caused equities to plunge back into bear market territory. Through the end of the third quarter, markets have retraced and given up nearly two years’ worth of previous gains, trading back to levels last seen in the fall of 2020.
Domestic equity markets finished the quarter down -4.9%, leading to year-to-date (“YTD”) returns of -23.9%, as measured by the S&P 500 Index. From a sector perspective, Communication Services (-12.7%) and Real Estate (-11.0%) fared worst for the quarter, while Consumer Discretionary (+4.4%) and Energy (+2.3%), were the only sectors with positive performance. Energy continues to remain the lone sector with positive performance on the year, up +34.9% YTD. While still negative for the period, growth stocks slightly outperformed value stocks on a relative basis across the market cap spectrum but have still fared decidedly worse over the year as earnings multiples have significantly compressed. The broad-based selloff in markets has caused valuations to reset, with all categories of global equities – domestic, international developed, and emerging markets – trading below their long-term (25-year) averages based upon historical price-to-earnings (“P/E”) ratios. Amazingly, earnings growth has remained somewhat resilient on a YTD basis, still up +5.1%, but is being monitored closely by market participants as go-forward estimates continue to be revised lower.
Developed international equities were down -9.4% for the quarter, with emerging market equities down -11.6%, as measured by the MSCI EAFE and MSCI Emerging Markets indices (in U.S. dollar terms). Remarkably, in local currencies, both markets have handily outperformed domestic equities for the year (-14.1% and -20.5%, respectively). However, when converted to U.S. dollar terms, both have underperformed (-26.8% and -26.9% YTD, respectively), highlighting the drastic effects of the strong U.S. dollar on foreign equity returns. The dollar index, a measure of its value against a basket of six major currencies, was up +7.1% in the quarter, its fifth consecutive quarterly increase, and is up +17.5% YTD. If the currency were to close the year at its current levels, it would represent its largest annual increase since free-floating exchange rates were introduced over 50 years ago.
Fixed income markets were down -4.8% for the period, as measured by the Bloomberg U.S. Aggregate Index. The index is down -14.6% YTD, continuing one of the worst years on record for the asset class. The Fed continued its hawkish posture, raising the federal funds rate another 150 basis points (1.50%) during the quarter to 3.00-3.25%, the highest it has been since 2008, while continuing to signal its intent to raise rates further. At quarter end, the U.S. Treasury yield curve was inverted, with short-term interest rates higher than longer-term interest rates as measured by the spread between the yields of 2-year (4.22%) and 10-year (3.83%) securities – a historic predictor of recessions.
Sustained Inflation and Historical Context
The massive changes in financial conditions as a result of an aggressive Fed have not yet had a meaningful impact on macroeconomic data, but we believe those impacts are coming and they will be significant. The much hoped for soft landing seems increasingly unlikely as the prospects of recession are high. – Global Fixed Income Manager
Inflation has remained stubbornly persistent throughout the year, despite the aggressive policy actions taken by the Fed and other central banks, with year-over-year Consumer Price Index (“CPI”) growth still above 8%, the highest it has been in decades. In fact, many economists argue that the current elevated numbers may even be understating inflation relative to history as there have been significant changes to the measurement methodology over time (e.g., the use of “owner’s equivalent rent” instead of actual home prices, the impact of substitution effects, etc.). If measured based upon the historical methodology, inflation would be in the mid-teens today.
Market participants have continued to be laser focused on inflation reports, with capital markets exhibiting heightened volatility around announcement dates. Markets breathed a brief sigh of relief during the first part of the quarter, as July’s CPI figures were essentially level with June’s, leading many to predict that inflation may have peaked. Equity markets rallied during the first half of the quarter on that news, particularly growth stocks, as investors also began to forecast a higher probability of a “Fed pivot” towards either smaller interest rate increases, or perhaps even interest rate cuts. However, subsequent monthly CPI increases led Fed Chairman Powell to raise interest rates further, and clearly signal that the central bank will continue its path until inflation is contained. While the Fed’s interest rate hikes have been aggressive from a historical perspective, they have not led to significant impacts on macroeconomic trends yet. The Fed has continued to signal (and markets have priced in) the probability of continued meaningful interest rate increases in the near-to-intermediate term, increasing the possibility of overcorrecting, and triggering a significant economic slowdown as a consequence.
Bond Market Volatility
In the GFC [Global Financial Crisis], the sharp rise in bond prices as interest rates plunged provided some offset to the collapsing stock market. In contrast, currently both stocks and bonds have provided significantly negative returns. – Multi-Strategy Hedge Fund Manager
As previously mentioned, the negative returns and poor performance of fixed income markets have been significant, and unprecedented from a historical perspective. Most investors have traditionally viewed fixed income as the stable, more conservative portion of their investment portfolio, that should provide ballast during periods of equity market stress. This year, given the trajectory and pace of the Fed’s interest rate increases, fixed income markets have sold off in tandem with equity markets, been highly correlated, and provided little-to-no relief. In fact, a traditional 60/40 portfolio (60% equity and 40% fixed income) is down more than 20% this year, marking one of its worst years ever. While we have been intentional for several years in portfolio construction around taking less interest rate risk than the overall market (through shorter duration strategies), incorporating non-traditional fixed income into portfolios, and being mindful of a market that has been artificially supporting by central bank liquidity, our portfolios have not been entirely immune from the drawdown in markets.
We expect that volatility will continue; however, on the bright side, also acknowledge that traditional fixed income is starting to look attractive for the first time in many years. As prices have gone down, yields have increased markedly, particularly on the short end of the curve (fixed income prices and yields are inversely related, so when prices go down yields go up and vice versa). We acknowledge that risks remain, particularly as the Fed remains aggressive in its policy actions and liquidity continues to get drained from the market; however, we believe that most of the pain is likely behind investors in this part of the market cycle. At some point, technical factors and competition for capital will provide support as yields become even more attractive, particularly in comparison to other asset classes. Interestingly, as one of our investment managers recently pointed out, only 11% of the stocks in the S&P 500 have a dividend yield higher than that of the 2-year U.S. Treasury bill, levels not seen since 2006.
With the recent decline in valuations, much of the froth has been taken out of the market and absolute price-to-earnings ratios as well as overall spreads (the delta between expensive and cheap) are much closer to historical norms. – Global Equity Manager
Coming into 2022, equity valuations were elevated, but have fallen significantly, with the S&P 500 trading at approximately 15.1x forward earnings as of quarter end, versus its 25-year average of 16.8x. As previously mentioned, most of this year’s equity market drawdown has been driven by multiple compression and not earnings deterioration (which may, and likely will, still happen as the economy contracts and we enter a recessionary period as most believe). While valuations today may not appear downright cheap, particularly given the continued economic uncertainty, they are undeniably more palatable than they were 12 months ago. For long-term investors and those that may want to be opportunistic with cash to deploy, today’s prices may provide some interesting entry points. In certain portions of the market, such as small cap stocks, forward valuations are the cheapest that they have been since 2009. International stocks (as measured by trailing 20-year P/E ratios) are trading at nearly a 30% (two standard deviation) discount to their U.S. peers.
While we are in a volatile market currently, with no shortage of risks to consider, we believe it is important to continually remember that a disciplined investment approach, coupled with a long-term perspective, are critically important for investing success. We expect that volatility will persist over the near-term, however, we will continue to be diligent about using volatility to our advantage by repositioning and upgrading portfolios where we are able and taking advantage of tactical investment opportunities that present themselves. We have also been working hard to harvest tax losses in portfolios (where appropriate), to help offset current and future capital gains, and thus lower tax liabilities.
Periods such as the one we find ourselves in are challenging for investors. While it is easy to get caught up in the current negative sentiment and headlines, history has shown that remaining diversified, taking a long-term perspective, and sticking to a thoughtful investment plan have been the best course for achieving successful investing outcomes. Equity markets typically bottom well before economic conditions trough, and no matter when that is, those that remain disciplined through market drawdowns have been rewarded with strong returns that have followed.
As always, we welcome the opportunity to discuss your portfolio in detail and appreciate the trust and confidence that you have placed in Prairie Capital.
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