Dear Clients and Friends,
Welcome to our review of the third quarter of 2022. In this article, we aim to give a very high-level, data-driven summary of what we observed about the economy and the markets during this quarter. This is meant to paint a very broad picture of very complex topics, so if you wish to delve deeper into anything you read, please reach out with questions or comments. After all, these weekend readings are meant to be educational and engaging.
Introduction
September 2022 saw the markets test new lows while the quarter’s previous gains were wiped away. Interestingly, while Tech fell the hardest during the month of September, it still led the major indexes for the quarter as a whole. These drops came despite strong fundamentals, as fears over interest rates and inflation won out over a strong U.S. labor market and resilient consumer. The Fed’s aggressively hawkish stance on interest rates put pressure on bonds and stocks alike. The silver lining here is that the short end of the yield curve rose more than the long end, so at least savers are making some interest on their savings accounts.
International markets didn’t fare much better in Q3. European economies grappled with the same headwinds that we dealt with here at home, in addition to supply chain issues exacerbated by Russia’s war in Ukraine.
By the numbers
· Technology (Nasdaq Composite Index): -4.96%
· Fixed Income (Bloomberg Aggregate Bond Index): -5.33%
· U.S. Stocks (S&P 500 Index): -5.88%
· International Developed Markets (MSCI EFA): -10.58%
· International Emerging Markets (MSCI EM): -12.47%
The Fed
The biggest contributor to this quarter’s market volatility was the Fed’s aggressive rate hikes. The Fed raised rates a cumulative 1.5% during their July and September meetings. With headline inflation readings hitting levels not seen since the 80s, it doesn’t seem like they had much of a choice in this “damned if you do, damned if you don’t” scenario. Now the question is: what comes next? Looking at the Fed’s own projections, it is likely that there will be a few more rate hikes over the next 2 quarters, followed by fewer and smaller rate hikes in late 2023 and early 2024. It takes a while for the effect of these rate hikes to work their way through the system, and it would be wise to stop and take stock before proceeding forward blindly. Our base case looks like another 1.5% hike throughout the next quarter, but these projections can change as economic conditions develop. Expect continued volatility as the Fed’s direction becomes clearer, but the worst of it may already be priced into markets.
Fundamentals
As mentioned above, markets fell in Q3 despite a resilient underlying economy. The biggest slowdown came in the housing sector. After prices skyrocketed in 2020 and 2021, rising mortgage rates and elevated prices seem to be cooling things down finally.
The labor market remained resilient throughout the quarter. While the pace of hiring slowed, it remained positive throughout Q3. Unemployment claims rose slightly during the summer but have remained at very healthy levels. The unemployment rate stayed right around 3.5% during the quarter.
This healthy labor market has translated into a resilient consumer. Retail sales and personal spending levels rose higher than analysts had expected, driven by increasing wages and improving consumer sentiment. This is a very encouraging sign, as the U.S. consumer accounts for almost 70% of our GDP.
On the business side of things, the trend remains positive. July and August saw durable goods orders rise for a 5th and 6th consecutive month. The U.S. service sector (which accounts for 80% of the U.S. economy), while down from 2021’s explosive levels, remains in positive territory. The manufacturing side of the economy saw business conditions deteriorate, but this reading remains in positive territory as well. It is not surprising to see this particular metric slow down, as energy prices soar and supply chain issues are exacerbated by Russia’s offensive in Ukraine.
While the fundamentals look relatively stable, the third quarter did confirm a second negative reading for U.S. GDP. While this does put us within the technical parameters of a recession, we have yet to see other segments of the economy be heavily impacted. Furthermore, the Fed and the I.M.F. both project slow, but stable, GDP readings for 2023 and 2024, with economic conditions improving. Look for a positive third quarter GDP reading (spoiler alert: as of writing this article, the number came out as a positive 2.6%) and modest growth going forward.
Technicals
(You may want to skip this section if you have a weak stomach!)
Despite the encouraging numbers seen above, Q3 saw markets retest their lows and then some. This drop almost felt like a self-fulfilling prophecy, as gas prices soared, GDP fell for a second consecutive month, and geopolitical headwinds soured sentiment. Take a look at the graph below…
The top chart is a graph of the S&P 500 over the last 24 months. The 3 lines overlayed on the chart represent 50-, 200-, and 400-day moving averages. These averages are used by traders to track trends and signal inflection points. They can also set “floors” or “ceilings” for the markets. Think of these as areas where the market will either rebound or break through. When the 50-day moving average crosses over the 200-day moving average, it can signal a short-term negative sentiment for the market. When the 200 crosses the 400, it is typically a signal of a more prolonged negative market sentiment.
The second chart shows the Relative Strength Indicator (RSI). Simply put, when this number reaches 70, the market is seen as being “over-bought.” When this number hits 30, the market is seen as being “over-sold.”
Finally, the bottom graph shows the Moving Average Convergence/Divergence (MACD). To oversimplify, when this number is positive, momentum is up, and when this number is negative, momentum is down.
By observing these indicators, we can often draw conclusions on the sentiment of the markets. As we can see on the chart, the market was approaching the 200-day moving average heading into September. This means it was likely to either rebound or break through. The 200-day moving average was also approaching a crossover on the 400. At the same time, the RSI told us that the market was overbought and the MACD told us that momentum was slowing. With all of these indicators aligning at once, in addition to the war in Eastern Europe and the most aggressive Fed rate tightening since the 80s, it was no surprise that the markets fell the way they did.
Inflation
This brings us to what is likely the biggest concern on everyone’s mind: inflation. As the Fed overtightening rates is likely the biggest risk to the global economy, and the Fed raises rates to combat high inflation, where inflation goes from here is quite important.
Over the course of Q3, headline CPI rose as high as 9.06% and then retracted to 8.26%. Core CPI, which strips out volatile sectors such as Food and Energy, hovered around 6%.
Soaring inflation has mostly been caused by the following sectors: Shelter, Automotives, Food, and Energy.
Soaring home prices and 7% mortgage rates have slowed down the red-hot housing market, and we expect this trend to continue. The headline CPI Shelter number has not yet fallen in response (because rentals are included in this figure), but one would expect that to follow suit. Vehicle prices continued to rise throughout the quarter; however, the rate of change slowed dramatically, and prices are projected to drop over the remainder of the year. On the other hand, food prices continued to rise throughout the quarter. As much of the world’s grain supply comes from Eastern Europe, this is no surprise to anyone. Energy prices peaked in June and have been dropping consistently since then.
It is hard to draw conclusions from this set of data, as there are a lot of factors at play. We expect Shelter and Automotive costs to continue to ease; however, food and energy prices will largely be affected by geopolitical events that are out of our hands. That being said, we are seeing signs that inflationary pressures are beginning to ease and that the worst of it may be behind us. Only time will tell.
Conclusion
Despite continued headwinds, the economy continues to chug along impressively. The labor market has remained very resilient, which has led to a strong U.S. consumer. While the underlying fundamentals remain strong, sentiment is negative; it will probably take a meaningful event (such as the easing of tensions in Eastern Europe, or a change in the Fed’s stance) to shift the markets back into growth mode. For now, we expect the markets to remain volatile and to trade within the corridor they have been confined to for much of the second half of the year. Continued poor sentiment could certainly see the markets test new lows.
We hope you found this weekend reading informative and helpful in regard to understanding the economy and the market’s behavior.
Have a lovely weekend, everyone.