"The Fed is going to need great skill and also some good luck to achieve what we sometimes call a soft landing.” - Secretary of the Treasury Janet Yellen
2022 Q3 Market Recap
Secretary Yellen’s insights did not forestall further negative returns for financial assets. In the third quarter of 2022, the stock market continued the downward trajectory which began in the first half of the year. The broad market, as represented by the S&P 500 Index, returned -4.9%. The total return for the Index in the first nine months of 2022 was -23.9%. Negative total returns were experienced across almost all segments of the market. Large capitalization growth stocks generated a return of -3.9% in the quarter and -30.4% for the first three quarters. Large capitalization value stocks returned -5.8% in the recent quarter, and -16.6% for the first nine months of 2022.
Small capitalization stocks experienced disappointing returns as well. The S&P Small Cap Index returned -5.2% for the quarter and -23.2% for the nine-month period. Subsets of the small cap universe showed a similar pattern of returns. The S&P Small Cap 600 Growth Index generated a -3.4% return in the third quarter and a -26.2% return for the nine-month period. The S&P 600 Small Cap Value Index experienced a -6.8% return in the recent period and -20.0% for the nine-month period.
At the end of the third quarter, the price to earnings ratio (PER) for the S&P 500 Index was an estimated 18.1 times trailing twelve months earnings. The PER was as high as 26 one year ago. The decline in the ratio often follows an increase in interest rates and an expectation for a slowing in the rise of corporate profits. The outlook for corporate profit growth has reflected the diminished confidence for positive economic growth in the near term. The current estimate for the change in corporate profits envisions a roughly 2.5% increase on a year-over-year basis in the third quarter and increases well below the rate of inflation for the next few quarters. It is likely real corporate profits will decline over the next few quarters as inflation remains higher than increases in nominal profits.
Fixed income assets with maturities beyond one year have not been a haven in 2022. The Bloomberg US Aggregate Bond Index returned -4.8% in the third quarter and -14.6% in the first three quarters. US Treasury bills in the 1-month to 3-month maturity range have produced small positive returns; 0.47% for the third quarter and 0.64% for the first three quarters. For all of 2022, bond prices fell as the Fed raised short-term rates and inflation remained unacceptably high.
As a direct result of the Fed’s efforts to reduce inflation by raising interest rates, the yield curve was inverted at the end of the third quarter The one-year Government obligation had a yield of approximately 4.2% and the ten-year obligation yielded 3.9%. Prior to each of the last seven recessions the yield curve has been inverted. There is no certainty a recession will follow the current inversion, but market participants are aware of the past relationship between an inverted yield curve and a contraction in economic activity. The economy experienced two consecutive declines in output in the first two quarters of 2022; further declines in output would very likely push asset values down from current levels.
The consensus forecast for the economy in the near-term is for real GDP to grow at a rate of less than 1% in the third quarter and for output to decline in the fourth quarter of 2022. Economic conditions deteriorated during the first nine months of 2022. Real disposable income declined as wage increases lagged the rate of inflation. Housing starts have declined as mortgage rates rose in concert with increases in the Fed Funds rate. Retail sales increased in nominal terms but showed little or no increase after adjustment for inflation. The savings rate declined precipitously as individuals dipped into their savings to cover the loss in purchasing power produced by rapid price increases. The Index of Industrial production was little changed over the second and third quarters. Some positive economic conditions included strong employment numbers and an increase in consumer confidence in September.
The paths of monetary and fiscal policies have produced concerns among investors. The Fed has raised the Fed Funds rate from a range of 0.0-0.25 one year ago to a range of 3.00-3.25 currently as it attempts to reduce the rate of inflation from more than 8% to 2% or below. The Fed has stated it intends to reduce economic activity as part of its effort to lower inflation. The decline in real output in the first two quarters of 2022 are direct consequences of that effort. Thus far, the rate of inflation remains high, and investors are left to wonder how far rates will be raised, and when will positive real growth resume. The Fed seems unaware of the tenuousness of the relationship between interest rates and inflation. High interest rates have been associated with both falling and rising inflation rates in the past. On the other hand, there is a stronger relationship between rates of growth of the money supply and inflation. There is a danger the Fed will raise rates to a level inconsistent with positive real growth and economic stability and not achieve its objective of reducing inflation below its 2% target.
Fiscal policies are not consistent with the objective of lowering inflation. The Biden Administration is intent on raising tax rates, increasing regulations, and maintaining a budget deficit of $1trillion. Raising tax rates and increasing regulations will likely lower real growth, and a large deficit will need to be financed without assistance from the Fed as it sells bonds to reduce liquidity and raise interest rates. Lowering output will reduce the amount of goods and services available and raise inflation, all other things being equal. The lack of consistency across policies reduces the likelihood the Fed will produce a soft landing.
International events in the last year have influenced the outcomes of domestic economic policies. The Russian invasion of Ukraine has led to rising oil prices and an uncertain supply of oil and gas in most of the EU. These conditions have lowered real economic growth in nations who are our trading partners. The demand for US goods and services will likely fall as economic growth slows overseas. In addition, the value of the dollar has risen against most major foreign currencies. A stronger dollar will further depress the demand for US goods, all other things being equal.
Given the trends in place currently, it is unlikely economic conditions will become significantly more favorable in the next few quarters. The Fed’s approach for reducing the rate of inflation to below 2% will require short-term rates be raised further. Higher rates are not consistent with a return to trend line real GDP growth and an increase in real corporate profits. Fiscal policies and declining economic growth overseas will add to the downward pressure on GDP growth and profits.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report is subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.