US Economy: Good news is bad news.
In a vacuum, recent data paints a positive economic picture as personal income (+0.3%), spending (+0.4%) and labor force participation (62.4%) all rose in Sept. while consumer sentiment (58.6) is slightly up from all-time lows. However, with core inflation running hot (+6.2% Core PCE), “hawkish” Fed policy to slow the economy is likely to continue.
US Stocks: Bad start to autumn.
Septembers have frequently challenged equity markets and did so in 2022 as U.S. large-cap stocks fell more than 9%, bringing the S&P 500 back to its level at the start of Dec. 2020 with losses across sectors: Only defensive health care stocks (-2.6%) were down less than 7.5%. Analysts have cut their estimates for quarterly earnings growth by the most since early 2020.
Foreign Stocks: Currency woes.
The tremendous 2022 rally in the U.S. dollar has been a formidable currency headwind for international equities and emerging economies. In Sept., currency translation detracted about 3% from foreign stock returns. Notably, the pound hit near parity with the dollar, as new British PM Liz Truss proposed cutting taxes and loosening fiscal policy.
Fixed Income: Volatility spikes.
The bond market rout deepened, as 10-year US Treasury yields rose nearly 80 basis points to 4.0% before returning to 3.7% in early Oct. While many investors were looking for equity market volatility to peak before calling a market bottom, bond market volatility spiked to levels last seen in 2008 during the global financial crisis, a potential sign of market capitulation.
Real Assets: Cooling off.
Real assets have been a reasonably effective diversifier amid broadly negative financial markets in 2022 but Sept. broke the trend. Concern about a weakening global economy led all major commodity sectors into negative territory. Meanwhile, REITs continued their slide on rising interest rates, which have made bonds relatively more attractive from an income perspective.
Alternatives: Hedge funds plug on.
Absolute return hedging strategies continued to benefit from market volatility, while managed futures strategies benefited from the upward trend in interest rates. Although equity-biased strategies struggled in Sept. as hedges were not totally offsetting the magnitude of the equity selloff, they also acted as shock absorbers relative to traditional equities and fixed income.
Equities Total Return
|U.S. Large Cap||(9.2%)||(23.9%)||(15.5%)|
|U.S. Small Cap||(9.6%)||(25.1%)||(23.5%)|
Fixed Income Total Return
|U.S. Agg. Bond||(4.3%)||(14.6%)||(14.6%)|
|U.S. High Yield||(4.0%)||(14.6%)||(14.1%)|
|Munis Broad Mkt||(3.7%)||(12.6%)||(11.8%)|
Non-Traditional Assets Total Return
|Overall HF Market||(0.9%)||(4.5%)||(4.4%)|
|Gold Spot $/OZ||$1661||$1937||$1757|
|U.S. Dollar Index||127.4||116.9||114.7|
“May you live in interesting times” is an expression used ironically with which you might curse an enemy. The notion is that it is better to live in periods that are uneventful versus those that are marked by change, such as what we have lived through since March 2020, and from a market perspective what we have experienced so far this year. Without doubt, we are living through a macroeconomic and market environment with few comparisons through history.
One key driver of the dismal market performance in 2022 that has not received much attention is the shrinkage in the global money supply. Since this spring, the Fed has been essentially closing not one but two spigots of monetary support: It has been raising interest rates since March and selling bonds on its balance sheet since May. The resulting drop in liquidity is indeed a shock after the massive influx of money to offset the economic impact of Covid. The Fed’s ability to manage both these maneuvers delicately without overcooling the economy and disrupting financial markets remains the greatest risk we see ahead of us.
Much tighter monetary policy coupled with relatively high inflation is negatively impacting both stocks and bonds simultaneously. As a result, the staple 60/40 stock/bond portfolio is down more than 21% this year through Sept. Were that to be the full-year return for 2022, it would make this the 60/40’s worst calendar year in at least five decades. Also, because the 2022 bear market is occurring 14 years after the global financial crisis in 2008, it has dragged down long-term performance results (the past three, five, and 10 years) for public market investments, which nine months ago looked much more respectable.
What Has Worked
While the reputation of the 60/40 portfolio has taken a hit as an all-weather investment strategy, diversification has worked, albeit less than investors would have preferred and it has come from places other than traditional fixed income: Lower market sensitivity investments within public markets such as real assets (infrastructure, commodities) and short-term bonds have provided some ballast whereas private market exposures and hedge fund strategies have also added value. Our point is that extensive diversification is continuing to add value and that investors would be worse off without it as global equities have fallen nearly 26% year-to-date.
In challenging years like 2022, it is too easy to lose sight that there are also potential positive catalysts that at some point can and will change the sentiment, the direction of markets and the economy, including: the Fed slowing or stopping further rate hikes; the end of China’s Zero-Covid policy, which could happen as soon as mid-October during China’s 20th Communist Party Congress; a potential end to the war in Ukraine, and other developments that are not on our radar screen today. The current environment is not without opportunities as well. The spike in short-term rates has distorted the yield curve so that short-term bond yields now mirror those of long-term bonds. It may be possible to improve portfolio risk-adjusted returns by locking in those higher relative yields at the expense of cash and other short-term investments.