Amid economic contraction and significantly elevated inflation levels, financial markets experienced a difficult third quarter. In fact, this marked the first time that stocks and bonds posted three consecutive quarters of negative returns over the past five decades. The causes of the current malaise are many, but the unwinding of coordinated global monetary stimulus due to inflationary pressures is certainly a major contributor to the current environment.
Second quarter GDP for the United States was reported to be -0.6%, marking two straight quarters of economic contraction, which fits a common description of a recession. An official recession designation from the National Bureau of Economic Research has yet to be pronounced as employment, consumption, and income levels are still relatively healthy. Given the backdrop, most economists believe a recession is underway or will arrive soon, and any economic growth will be subdued for the foreseeable future.
Although inflation may have (hopefully) peaked with the 9.1% CPI reading for June, inflation continues to be problematic and remains near 40-year highs. The Federal Reserve’s preferred inflation metric, the core PCE index, increased 4.9% year-over-year in August, above expectations and higher than the previous reading. This number is of course well above the central bank’s 2% long-term target, and likely means the tightening cycle the Fed has begun still has a long runway ahead.
The Fed has made fighting inflation its top priority. To this end, the Fed Funds rate has seen three consecutive 75 basis point increases and now has an upper range of 3.25%, up from 0.25% at the beginning of the year. The market expects further hikes, and the Fed Funds rate is likely to end the year near 4.50%. In addition to increasing rates, the Fed has also begun a quantitative tightening program. This involves the unwinding of nearly $9 trillion from the Federal Reserve’s balance sheet, which had been accumulated over many years. These actions by the central bank are intended to bring down inflation; however, it is also quite possible that they may slow the economy even further.
Labor markets remain strong, with the unemployment rate inching higher to 3.7% in August. Encouragingly, the labor force participation rate ticked higher, and average hourly earnings increased at a steady rate. Consumer confidence increased for the second straight month in September supported by the strong jobs market and declining fuel prices. However, the housing market has begun to come under pressure as mortgage rates have more than doubled since the beginning of the year. Pending home sales have dropped over 20% compared to a year ago, and home prices are showing early signs of cooling off. Given this backdrop, the consumer is still in decent shape to support the economy for now, but any changes to present level of consumer confidence will need to be monitored.
While the U.S. appears to be experiencing recessionary conditions, some international economies are in more dire straits. Of course, the war in Ukraine has played a large part in surging food and energy prices, especially in Europe, where inflation reached 10% and placed even further pressure on Central Banks there. China has experienced much slower growth as it continues to deal with COVID-19 lockdowns and an increasingly problematic property market. The strong U.S. dollar presents a further headwind for many international economies as they try to escape both inflation and recession concerns.
The Fed maintained its aggressive posture toward inflation with another 75 basis point rate hike enacted at its September meeting. Given the tightening backdrop, bond yields again moved significantly higher during the quarter. Yields on the 2-year Treasury Note rose by 133 basis points to 4.28%, while 10-year Notes rose 82 bps to 3.83%.
This dynamic of shorter-term rates rising faster than longer-term rates has led to an inverted yield curve. The 2-year Treasury has had a higher yield than the 10-year bond for most of the third quarter. An inverted yield curve is often associated with a recessionary period, especially when the inversion lasts for a period of time.
As bond prices generally move in the opposite direction of interest rates, returns on bond indices were negative for the quarter and have seen some of their poorest 12-month returns against the backdrop of sharply higher rates. While rising rates account for much of the sell-off in bond prices, spreads (additional yield paid over Treasury yields) on corporate debt widened during the quarter, leading yields for these issues to grow even higher and causing indices representing corporate bonds to lag the general bond market. High-yield bonds somewhat surprisingly held in well during the quarter, while municipal securities continued to fare relatively well.
As to how long the tightening cycle would last, Fed Chair Jerome Powell succinctly answered that the Fed would continue hiking rates until inflation was under control. Currently, the bond market expects rate hikes at both FOMC meetings to take place during the fourth quarter. The Fed Funds Rate is likely to end the year near 4.5%. If investors believe inflation will remain problematic even after the rate hikes, then longer rates may move higher as well.
Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).
|Fixed Income Returns|
3rd Qtr. 2022
Last 12 mo.
|BBerg US Aggregate Bond Index||-4.75%||-14.60%|
|BBerg Intermediate US Gov./Credit Index||-3.06%||-10.14%|
|ICE BofA US Corporate Bond Index||-5.11%||-18.19%|
|ICE BofA US High Yield Bond Index||-0.68%||-14.06%|
|BBerg Global Aggregate Bond Index||-6.94%||-20.43%|
|ICE BofA US Municipal AAA Securities Index||-2.22%||-7.09%|
Equity markets declined broadly and sharply during the quarter, and the S&P 500 is on track for its worst year since 2008. The S&P 500 closed the quarter at a fresh 2022 low, as the market’s price to earnings (P/E) multiple has declined and investors wait to see if earnings will match prior expectations.
For the quarter, the S&P lost just under 5%, bringing its year-to-date loss to nearly 24%. The NASDAQ, heavily weighted with growth-oriented tech companies and a long-running market-leading index, has dropped 32% so far in 2022, but had a slightly narrower loss than the S&P 500 for the quarter. In general, growth stocks showed relative outperformance for the third quarter, but have significantly lagged value stocks for the year-to-date period. In fact, value stocks are among the only indices not to have a drop of over 20%, a common definition of a “bear market.”
International stocks had a difficult quarter amid surging inflation, declining economic growth, and geopolitical issues, especially with the war in Ukraine. For the quarter, developed international stocks dropped over 9% while emerging market stocks fell over 11%. Year-to-date, non-U.S. stock indices are down in the 25%-30% range, slightly below the S&P 500 benchmark.
Volatility is often associated with down markets, and 2022 has been no exception. According to Strategas Research, during the first nine months of 2022, 88% of trading days have seen intraday movement of greater than 1%, the highest level since 2009.
Slowing economic growth, rising input costs, and higher interest expenses will undoubtedly pressure corporate profits. Expected earnings growth is falling and has been a contributor to weak stock prices. The key debate going forward is whether earnings estimates have been lowered enough given the increasingly uncertain macro backdrop; and secondly, once a bottoming of earnings has been reached, when might a recovery occur? Although stock price levels have adjusted substantially to date in 2023, volatility will likely continue as the market attempts to answer these questions.
Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).
|Equity Indices||3rd Quarter 2022||Last 12 mo.|
|Dow Jones Industrial||-6.17%||-19.72%|
|S&P 500 Growth||-3.86%||-30.42%|
|S&P 500 Value||-5.83%||-16.59%|
|Russell 2000 (small-cap)||-2.18%||-25.11%|
|MSCI/EAFE (developed international)||-9.26%||-26.71%|
|MSCI/EM (emerging markets)||-11.46%||-26.99%|
During the broadly negative third quarter, there was some real dispersion in sector returns; however, a common theme is difficult to ascertain. Consumer Discretionary was the top-performing sector, while Energy stocks were able to regain some of their upward momentum. Financial stocks also performed slightly better than the market in general, as higher interest rates may increase profitability of many companies in that sector.
However, higher interest rates likely dampened enthusiasm for some sectors of the market, like Real Estate, which was one of the worst performers for the quarter. Communication Services was the worst sector, mostly as a result of legacy providers under pressure during the quarter. Somewhat surprisingly, traditionally defensive sectors like Staples and Utilities underperformed the market despite their usual “safe haven” status in a down market.
The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).
|Return by Stock Sector||3rd Quarter 2022|
|1. Consumer Discretionary||-4.62%|
|7. Information Technology||-15.90%|
|8. Consumer Staples||-17.50%|
|9. Basic Materials||-20.24%|
|10. Real Estate||-20.71%|
|11. Communication Services||-26.16%|
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