Global markets declined again in Q3 2022 as inflation remained near multidecade highs, geopolitical tensions escalated further, and the Federal Reserve (the Fed) continued to hike interest rates, signaling its commitment to keeping rates higher for longer.
Quarter Starts With Midsummer Rally
The third quarter started strong with a rebound in stocks and bonds driven by resilient corporate earnings and hopes of a quick decline in inflation and sooner-than-expected Fed pivot.
Corporate earnings reports for the second quarter were better than predicted, despite high inflation and lingering supply chain issues.
The markets responded favorably to comments from Fed Chair Jerome Powell in late July, when he said it would be necessary for the Fed to slow the pace of interest rate hikes in the future.
Investors read those comments as a sign that the Fed might be closer to the end of the rate hiking cycle than previously thought. The combination of good earnings, signs of peaking inflation, and hopes of a less-aggressive Fed fueled a 9.2% gain in the S&P 500 in July, its best monthly return since November 2020.
That interpretation was premature, however.
Small Cap and Growth Outperform
Early in the quarter small-cap stocks outperformed large-cap stocks for the first time this year and growth outperformed value. However, the outperformance shrank late in the quarter as inflation remained stubbornly high and the Fed signaled the end of the rate-hiking cycle wasn’t imminent.
Disappointing Inflation Data and a Persistently Aggressive Fed
The August Consumer Price Index (CPI) released in September showed no signs that inflation declined towards the Fed’s target. Powell clarified his position from the Jackson Hole Economic Symposium, more clearly dismissing the idea of a pivot to less-aggressive Fed policy. Other Fed officials repeated this position in the following weeks.
The continued aggressive policy following historically large rate hikes, combined with the disappointing CPI report, hit stocks late in the month. The S&P 500 gave back all the early August gains to end the month down 4%.
Geopolitical concerns also weighed heavy on stocks late in the quarter as Russia escalated the war in Ukraine, holding referendums in occupied Ukrainian territory, and mobilizing 300,000 reservists.
President Joe Biden called the referendums a sham.
Currency Dislocations Add Volatility
Global currency and bond markets saw a dramatic increase in volatility late in the quarter, as the government of the United Kingdom announced a spending package designed to stimulate the economy.
The market reflected worries that the package would add to already high inflation in the region, resulting in a spike in global bond yields while the pound collapsed to an all-time low against the dollar, adding to general macroeconomic volatility.
Foreign markets underperformed compared to US markets during the third quarter as surging electricity prices in Europe and the UK, interest rate hikes by the European Central Bank and Bank of England, and continued geopolitical risks weighed heavily on foreign developed markets.
Emerging markets underperformed compared to both foreign developed markets and US markets as a strong US dollar offset hopes for a continued economic reopening in China.
Commodities dropped sharply in the third quarter. The drop was precipitated by a combination of the US dollar’s multi-decade highs, fears of a global recession, and sharply rising real interest rates, which affected industrial commodities as well as traditional safe havens like precious metals.
Oil prices fell in the quarter as concerns about future demand offset geopolitically based worries about supply. Gold, meanwhile, showed negative returns for the second straight quarter thanks to rapidly rising real yields, the surging dollar, and fading market-based inflation expectations.
Most bond indices posted negative returns for the third straight quarter.
Stubbornly elevated inflation, continued Fed rate hikes, and a late-quarter selloff in global sovereign bonds driven by a surprise fiscal spending package from the United Kingdom saw most bond classes end the third quarter lower, extending the year-to-date declines.
Outlook for the Rest of 2022
It’s likely there will be softening in the inflation data as the Fed’s tightening mechanisms filter through the economy.
Commodity prices, somewhat hostage to geopolitical risks, are a wild card.
The probability of a recession is increasing with most estimates in a range of 30%–60%, which appears reasonable.
If the economy goes into recession, it’s likely to be moderate given the underlying strength of both consumers and companies.
The fixed income markets are pricing in another 125 basis points of Fed rate hikes through year end.
Short of any surprisingly positive inflation data, they will likely execute exactly that over the next two Fed meetings.
Maintain Your Portfolio
Equity valuations have come in substantially. The S&P 500 began the year with a price-to-earnings (PE) multiple near 23 times. The PE ratio today is closer to 15 times and trading at a valuation level that has, historically, been attractive over the longer term.
Many sentiment indicators have hit or are nearing levels of extreme pessimism and bearishness, historically an indicator that the bottom may be close.
In the fourth quarter markets will likely see continued volatility as investors search for more concrete signs that inflation pressures are waning and that the Fed can become less aggressive.
Market volatility can be unnerving, but long-term investors have historically been rewarded for staying invested and not trying to time market actions.
Though the markets have been challenging, maintaining investment discipline—by staying invested and sticking to your plan— will be of crucial importance.
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