Q3-2022 Quarterly Newsletter
More Pain To Endure
There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.
What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data.
You should be prepared for more weakness in the short term in the market and be resolved to not make any knee jerk reactions to the bearish sentiment as this too shall pass. The Fed’s efforts to bring inflation down will take some time to work their way through the economy. Markets go through cycles and we are in a late cycle expansion phase with moderate recession risk as illustrated in the following chart. In this phase growth is moderating, credit tightens, and earnings come under pressure. The next phase is a recession, we believe a mild one, but then the cycle resets and the early growth phase will re-establish itself.
Source: Fidelity Quarterly Market Update Q3 2022
Since 1926, there have been 17 bear markets in equities. The average duration is 20 months and the average peak to trough decline is -36%. On that basis, we are approximately 2/3 of the way through the average bear market. But will this be an average bear market? We don’t believe so because the US economy is in much better shape than previous downturns with a strong employment picture and healthy consumer balance sheets. Bear markets are an important phase to removing excesses in the capital markets. In rescuing the world from the pandemic, nine trillion dollars in monetary and fiscal stimulus went into the economy which inflated growth and now the system needs to rebalance.
Let's review the markets.
The S&P 500 Index is down nearly -24% year to date including the effects of dividends. This is the worst performance in equities we have experienced since the Financial Crisis in 2008 when the S&P 500 index ended the year down -37%. As uncomfortable as it may seem, it is important to put this year’s market volatility into perspective. In 2019, 2020, and 2021, the S&P 500 index grew by almost 99% so a negative year, even a big one, should not be that unexpected. The technology heavy NASDAQ composite fared far worse losing -32.40% year to date.
The S&P 500 index now trades at 15.4 times 2022 forecasted earnings according to Yardeni Research and is finally within a more reasonable valuation unlike at the beginning of 2022 when the index was trading at 21 times earnings. In fact, other valuation measures like the CAPE ratio, Price to Book, Price to Cash Flow, and the Earnings Yield spread indicate that the index is trading in line with 25-year averages . Meanwhile corporate earnings for the second quarter were much better than feared despite higher inflation and lingering supply chain issues.
Bonds have not been any help to portfolios this year and are on pace for their worst year ever recorded as measured by the Bloomberg Barclays Aggregate Bond Index which is down -14.61% year to date. The decline in bond performance is due to a significant increase in yields in just nine short months. Traditionally, large moves in yields happen over many years - not months. The 10-year treasury yield has more than doubled in 2022 from 1.5% to 3.8% at quarter end and as yields rise, bond prices decline. Meanwhile, cash and cash equivalents have suddenly become interest bearing safe havens after years of returning 0%. Also, with this improvement in rates we are now finding attractive opportunities in taxable and tax-free bonds.
There was no bright spot to be found outside the U.S. either. Developed and emerging international equities, measured by several indices in the table above, underwhelmed due to several headline risks including the war in Ukraine, a strong dollar, inflation in Europe along with recession fears, energy crisis in the Eurozone, and ongoing political unrest.
Overall, an ugly year so far for all asset classes.
We believe inflation will trend lower for the remainder of 2022 but on an absolute basis, inflation will remain elevated through 2023. The so called “Fed pivot” or a reversal in Fed policy is unlikely until we see inflation back down to more reasonable levels. Until then, we expect continued volatility in both the equity and bond markets. To the extent that there is excess cash in your portfolio, this couldn’t be a more opportune time to invest that cash.
Markets tend to over exaggerate on the upside and over exaggerate on the downside, all the while mispricing true intrinsic value in assets. It’s imperative not to trade along with these swings but rather to establish an asset allocation based on your personal financial goals, risk appetite, and investment horizon, among other considerations, and methodically rebalance to this asset allocation taking advantage of the down cycles to be positioned for the upcycles.
In conclusion, the outlook for the markets and the economy remains challenged but we feel a lot of the bad news is priced in already with valuations now at levels that historically are attractive. As we start the fourth quarter, we remain cautious while constantly monitoring economic and financial market conditions looking for opportunities to buy assets at attractive valuations.
Our investment bias of not owning pure international funds or emerging market funds has proven itself time and time again and has isolated your portfolio from unnecessary risk. Our overweighting to large cap dividend paying domestic equities has been the best place to be in our opinion. To the extent that your portfolio has a fixed income allocation, our strategy to maintain a short duration while owning high quality domestic bonds has also proven to be defensive.
Patrick R. Wallace
Covington Investment Advisors, Inc. is a Federally Registered Investment Advisor. The information contained herein is general in nature and is provided solely for educational and information purposes and does not constitute legal, financial or tax advice. Opinions and forward-looking statements expressed are subject to change without notice. Past performance is no guarantee of future results. Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable and does not endorse, approve, certify or control the third-party content referenced.
: JP Morgan Asset Management Guide to the Markets Slide 5