Rollercoaster: Redefined in Q3 2022

by | Sep 27, 2022 | Market Updates

Market turbulence is an understatement of how markets are reacting to the Fed’s latest rate hike of .75 last week. We realize higher interest rates are not good news. We simply wish to explain the markets’ volatility and suggest that none of this was totally unexpected. We wrote in our quarterly newsletters throughout the pandemic that the framework was being laid for inflation by the Fed’s infusion of funds into the economy, while maintaining low interest rates. What we are currently experiencing is a logical result of quantitative easing. 

This Is What Volatility Looks Like

The S&P so far this year:  

  • January to early March -12%
  • Early March to end of March +11%
  • End of March to mid-June – 20%
  • Mid-June to mid-August +17%
  • Mid-August to mid-September -9%

This gives a new definition to rollercoaster.

Asset allocation strategies have delivered a similar jolt with double-digit declines this year. As we have spoken about many times, the correlation between stocks and bonds falling together is occurring more often. According to Morgan Stanley, nine instances in which the 60/40 fell more than 10% since 1980 within a given year. Yet, investors who were patient with their portfolios were often rewarded with a rebound. In five of those years, returns still ended the year positively. In eight of the nine instances, returns the following calendar year were positive, with an average return of over 17%. If you have tolerance for a little risk, we anticipate the financial markets to rebound over the next year or so. 

Fed Chair Jerome Powell’s Presentation

Powell’s speech on September 21 was hawkish in deeds and words. 

His overarching goal is to bring inflation down to 2%. To help achieve this, the Fed announced an interest rate increase of 0.75%, bringing rates to 3.75%. Although this is the highest interest rate since 2008, we cannot forget that rates settling between 4%-5% is well within historical norms. A healthy economy should be able to sustain interest rates at this level, theoretically. 

The Chairman’s rhetoric was also hawkish. He reiterated the Fed’s commitment to reducing the size of its balance sheet. 

While Fortis believes the Fed should practice quantitative tightening, this will probably present headwinds for stocks in the short term. He warned against becoming complacent in fighting inflation, even with improving conditions. He sounded convincing that the Fed will stay the course until price stability is achieved.  

Chairman Powell’s remarks about the health of the economy were somewhat confusing. He estimated the GDP will be 0.2% for 2022 and 1.2% next year, suggesting a major slowdown in growth. “No one knows if this process will lead to recession,” Powell said after his speech, adding that “chances of a soft landing are diminished” by the need for a restrictive policy. Yet, he still averred that we have a “strong, robust economy.”

Current Readings: 

Inflation expectations for the year ahead moderated to 4.8% from 5.2% in July, the lowest in eight months. The survey’s inflation expectations over the next five years fell to 2.8% from 2.9%.

Inflation and higher interest rates have broader implications, suggesting a looming possibility of a global recession or pullback. The strength of the US dollar is part of the problem. Many countries and corporations borrow dollars and now have to pay back their loans in appreciating dollars. 

Notably, Consumers have kept wearing their smiley faces throughout the quarter, despite inflation. Retail sales increased 0.3% in August after a downwardly revised 0.4% in July. Retail sales, which are primarily goods not adjusted for inflation, rose 10.3% in July on a year-to-year basis and increased 9.1% in August year-over-year. 

Retail may be improving because of a strong labor force and lower gas prices, which have fallen 20% since June.

The service sector has expanded for 27 consecutive months. We think that gains in retail numbers help reinforce the Fed’s case for higher interest rates. Holiday retail sales reports in the near future will clarify. 

The rise in retail sales may reflect consumers’ more positive attitude about inflation. The Consumer Sentiment Index rose from 58.2 in August to 59.5 in September, a five-month high. Declining gas prices may have been a major factor in the improved reading.

Labor Market

Goldilocks is alive and well. The U.S. economy added 315,000 jobs in August for a 3.7% unemployment rate. This is welcomed news for the Fed, as it suggests the economy is moving in the right direction.

One nascent problem is that wages grow as employers compete fiercely for talented employees. The median wage grew in July by 6.7%. Annual wage gains have exceeded 5% each month since January 2022. For people who switched jobs, the median wage growth was 8.5%, year-over-year in July. The August employment report showed that wage growth has started to mitigate, gaining 0.3%. We shall continue to report on future wage growth.  

The Underlying Reality

Economic news is sometimes skewed in one direction. This may sound counterintuitive, but on many levels our economy is performing well. 

  • There were 11 million job openings in September, and wages are increasing. 
  • The price of gas has declined throughout the summer.  
  • Manufacturing continues to accelerate.
  • Consumers continue to be resilient, as retail sales have increased.
  • In mid-August nearly 90% of stocks in the S&P were above their 50- day moving average.
  • Import prices fell for the first time in eight months in August.

It is essential to recognize corporate profits are at a 70-year high. Their profit margins improved to 15.5% in the second quarter. Being able to pass on higher labor and material costs to consumers, they are enjoying their highest level of profitability since 1950. Gross profits rose over $3 trillion in the second quarter, an all-time high.

Corporate profits suggest the underlying economy is strong. Yet inflation, financially and psychologically, overcomes any positive news. We are often asked when to invest in the market. When a high-quality company with low risk and moderate P/E value appears at the right discounted price, it is time to buy. Good companies will recover, and investing in them is always a good idea.

The rollercoaster ride we are experiencing in the equity markets, without the associated declines in corporate profits, reveals investor fears and speculation about the Fed overstepping its bounds is the primary trigger of market volatility.

 We urge investors to maintain a long view of the economy and markets. Stocks are obviously negatively impacted by higher interest rates, but this is a necessary crucible to create an improved and stable investment environment in the future. 

 Patience is the magic bullet.

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