The third quarter of 2022 wasn’t as bad as the terrible second quarter but it was still very hard on investors due to the ongoing uncertainty over inflation, interest rates and growth, not to mention the ongoing war in Ukraine and – after the quarter ended – the drama in the UK. The S&P 500 (a broad measure of large US stocks) fell another 4.8%, taking its loss for the year so far to 23.9%. International stocks did even worse, with the MSCI ACWI ex-US (all major global stock markets except the US) falling 9.9%. Most stocks in the US market fell, with the exception of the consumer discretionary and energy sectors, which posted small gains. Growth stocks did especially badly as investors sought cheaper alternatives and dividend paying companies with strong cash flow. Green energy stocks were a rare bright spot, gaining 9.1% (NASDAQ Clean Edge Green Energy Index) thanks to the passage of the Inflation Reduction Act with its substantial funding for the sector.
Bonds sold off just as much as equities, with the Bloomberg US Aggregate Bond Index down 4.7% for the second consecutive quarter. Year to date US bonds have lost 14.7%. This is the worst year in the 50-year history of the US bond indices.
It’s hard to overstate just how unusual it is for bonds to sell off at the same time as stocks. Since growth is usually positive for stocks – which benefit from the anticipation of higher future corporate earnings – and negative for bonds – whose holders fear that higher growth will lead to higher interest rates – the two asset classes usually counter-balance each other. Investors seek to profit from growth while protecting their savings by holding a mix of stocks and bonds (the classic ratio is 60% equities and 40% bonds). This strategy has worked most of the time for decades, helped by the long downward trend in US interest rates since 1982. This year’s bond sell-off meant that for most investors there was no place to hide.
Even though cash retained its nominal value, it still lost ground against inflation. The most attractive investment for many small investors turned out to be once obscure I-Series US Savings Bonds, which guarantee an interest rate above inflation with the full faith and credit of the US government behind them. Demand has been so strong that it has at times overwhelmed the US Treasury’s website.
Is Inflation Ever Going to Stop Going Up? Is the Federal Reserve Ever Going to Stop Raising Interest Rates?
Month after month Wall Street economists and others have predicted that inflation was peaking and month after month it continues to creep upward and spread more broadly across the economy. September annual inflation came in slightly higher than expected at 8.2%, the seventh straight month that it has been above 8%. Inflation in housing prices accelerated while groceries rose a record 13% over the previous year. Core inflation – which excludes food and energy because their prices are more volatile – rose 6.6%. This key indicator is now at the highest level in forty years.
When inflation was limited to particular sectors, it could be described as “transitory”. The massive spike in used car prices in mid-2021, for example, was clearly a temporary effect of the economy reopening after the pandemic shutdown and not something to be directly addressed by the Federal Reserve. Now the Federal Reserve is having to tighten relentlessly by 75 basis points (0.75%) at every meeting.
There are some preliminary signs that the Fed’s new-found aggressiveness is starting to work. In September wage growth slowed, even though unemployment remained at a record low level, while rents were actually down 2% after soaring for months. Soaring mortgage rates have caused sales of new and existing housing to slow. It is still too early to say if inflation is peaking and more interest rate hikes are expected still. These questions will continue to be a major driver of financial markets for the next few months as they have been all of this year.
Once again, it is important to remember that inflation is a global phenomenon. For example, annual inflation in the UK hit 10.1% in September and is expected to continue rising. Euro zone inflation is at 9.9%. The entire world is experiencing the same supply chain disruptions post-pandemic shutdown, the same need to tighten monetary policy after governments and central banks pumped out money to support the economy in 2020-21 and the same surge in oil and gas prices after Russia’s invasion of Ukraine. Central banks everywhere are racing to catch up with inflation: The European Central Bank just raised rates by 75 basis points for the second time. A notable exception is the Banco Central do Brasil, which reacted more quickly and where inflation is now lower than it is in many developed countries.
Is the Federal Reserve Going to Kill the Economy?
Much like the concerns over inflation and interest rates, the debate over whether or not the Fed will raise rates so aggressively that it triggers a recession continues much as it has all year. (see my second quarter commentary)
With inflation the highest it has been since the early 1980s it is easy to see parallels to that time when Fed Chair Paul Volcker raised interest rates into the double digits and the economy went into a sharp recession.
Here the latest indicators are somewhat contradictory. A key signal of an impending recession is the difference between the interest rate US three-month Treasury bills and ten-year Treasury bonds are yielding in the market (not the same as the fixed interest rate that they pay on their original principal known as the “coupon” but that is another story). Normally, the economy is expected to grow and investors demand a higher interest rate to lend to the government for a longer time. When investors are suddenly demanding a higher rate on three-month Treasuries than on ten-year Treasuries – known to the cognoscenti as a “yield curve inversion” – that is a sign that they are expecting a recessing. The yield curve has been inverted most of the time since July.
In contrast, preliminary third-quarter GDP numbers were just released and showed that after going into reverse in the first half of the year the economy grew at a 2.6% annual rate. And, as mentioned, unemployment remains at a multi-decade low of 3.5%. Nonetheless, there were signs of a weakening economy in the third quarter growth number, with consumer spending slowing from its previous pace and a decline in investment in housing.
Corporate earnings are also being closely watched for signs of a slowdown. Here too the signals are mixed. Tech giants Alphabet (Google, YouTube) and Meta (Facebook, Instagram) reported weaker revenues and profits. In contrast, heavy equipment giant Caterpillar – seen as an economic bellwether - reported strong demand from customers.
Another thing to worry about is the strength of the US Dollar as the Fed raises interest rates, making US financial assets more attractive to foreign investors. While this helps US consumers by making imports cheaper, it can have a significant negative impact on the rest of the world. Recession elsewhere would hurt demand for US exports, increasing the odds of recession here.
With all of these mixed signals, there is not a consensus on the outlook for US growth but most economists agree that the risk of one has risen in the last few months. The earlier optimistic forecasts that the Federal Reserve would once again achieve a “soft landing” of the US economy are heard less frequently now.
ESG: Under Attack but Still Going Strong
Republican politicians continue to step their attack on sustainable investing and on so-called “woke corporations”. In August, Missouri’s Attorney General Eric Schmitt (currently running for US Senate) declared that “Missouri has been a leader in pushing back against woke ESG Investing,” and announced consumer fraud investigations into investment research companies Morningstar and Sustainalytics. Schmitt also accused Morningstar of “anti-Israel bias”. Arizona gubernatorial candidate Blake Masters called ESG scores “an existential threat to America”. Florida Governor Ron DeSantis banned state pension funds from screening for ESG risks. In October both Louisiana and Missouri withdrew their public pension fund investments totaling approximately $1.3 billion from fund giant Black Rock in retaliation for its ESG supportive rhetoric (ironically, Black Rock has come under considerable criticism from sustainable investors for its extensive fossil fuel holdings, even in funds that are called “ESG-Aware”.)
This rhetoric, for all its ridiculousness, has real effects. Black Rock can afford to lose a few public sector clients who accuse it of being “woke” and may in fact be more at risk from sustainably minded investors angered by its “greenwashing”. The real victims may turn out to be the beneficiaries of public sector pension funds in Texas, Florida, Louisiana, Missouri, and any other state that follows their lead. The Texas municipalities are stuck paying more to issue bonds because the state has banned banks perceived to be “discriminating” against oil and gas producers and gun manufacturers are victims too. At bottom, the anti-ESG campaign looks like an attempt to help out a handful of favored industries at the expense of taxpayers.
Pension fund managers and sustainable investment professionals have been pushing back and turning the politicians’ arguments on their heads. Investors need to consider all potential risks to the companies they invest in. This is especially true of pension funds, which are long-term investors and need to be attuned to a wider range of risks. Not being allowed to incorporate an entire set of risks into their investment decisions may very well hurt their returns, especially since studies by Morningstar and others have shown that ESG investors have done better than their conventional peers over the last ten years. Many long-term investors such as Harvard University argue that NOT considering ESG factors is in fact a violation of their fiduciary responsibility to invest prudently. At some point, public sector pension funds that ignore ESG may face legal liability.
Meanwhile, sustainable investing marches on and green energy continues to attract investment. The UK recently generated a record 19.9 gigawatts of electricity from wind power and plans to reach capacity of 50 GW by the end of the decade, substantially reducing its dependence on natural gas. US solar panel manufacturer First Solar announced plans in August to invest $1.2 billion to expand capacity in the US while its competitor Enphase Energy reported a jump in revenue and plans to open four to six new US manufacturing lines. The Central African nation of Gabon (a member of OPEC) said that it intends to issue a $200 million green bond to finance clean energy projects. The politicians fighting ESG risk looking like King Canute trying to hold back the tide.
What’s Next for the Markets?
After such a terrible year it is natural to wonder if all the bad news is in the price, meaning that stock and bond prices now reflect an outlook of higher interest rates and slower growth. Certainly, bonds are now offering an attractive yield for the first time in several years while Morningstar calculates that stocks are now at a significant discount to their fair value. Both asset classes have started attracting investors back in recent days.
The counterargument is that corporate earnings estimates do not yet fully reflect the risk of recession and therefore stocks are not as attractive as they appear. Additionally, the widely followed Shiller Price Earnings Ratio (based on inflation adjusted company earnings over the last ten years) is currently at 28 times, down only slightly from 29 times three months ago and well above the long-run average. Meanwhile, bonds remain vulnerable to further interest rate hikes and to the ongoing shrinkage of the Federal Reserve’s balance sheet as it continues to unwind its massive bond purchases from 2020.
Markets will remain acutely sensitive to any inflation indicators, whether positive or negative, until there is clear evidence that monetary policy is working. Growth will also remain a concern. Historically, though, the stock market tends to do well when the end of a rate hiking cycle is in sight, even if the economy is slowing. And, of course, falling inflation and slower growth are very positive for bonds. In the next few months, we are likely to reach this inflection point when there is less uncertainty about inflation, interest rates and growth. There may be continued volatility to get through first, however.
Wild cards such as a Russian nuclear escalation in Ukraine or a Republican controlled House of Representatives move to threaten to default on US debt in order to extort spending cuts from the Biden administration could have dire consequences but are very difficult for investors to predict or prepare for. It makes to focus on more tangible issues as long as the risks of either of these events occurring remains low.
Urban Larson
Principal
For additional information, please visit our website at www.whitepineadvisory.com.
Photo by Timothy Eberly on Unsplash
White Pine Advisory LLC (“White Pine”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where White Pine and its representatives are properly licensed or exempt from licensure.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
When an investment process considers environmental, social, and governance factors (“ESG”), the advisor may choose to avoid investments that might otherwise be considered or sell investments due to changes in ESG risk factors as part of the overall investment decision process. The use of environmental, social, and governance factors may impact investment exposure to issuers, industries, sectors, and countries, potentially resulting in higher or lower returns than a similar investment or strategy without such screens.
Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.
Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
Although bonds generally present less short-term risk and volatility risk than stocks, bonds contain interest rate risks; the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk.
Past performance shown is not indicative of future results, which could differ substantially.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of White Pine's strategies are disclosed in the publicly available Form ADV Part 2A.