October 7, 2022
Global markets have left investors with few places to hide in 2022. Stubbornly high inflation has sparked the most aggressive interest rate increases by central banks in decades, contributing to concerns about recession. With stock, bond and commodities markets turning lower again in the Third Quarter, this is shaping up as the worst year for investors since the 2008-2009 financial crisis.
At the eye of the storm are inflation and interest rates. The Federal Reserve is determined to hike rates until inflation has been thoroughly subdued, even if doing leads to an economic slump. Chairman Powell has signaled several more increases in the Federal Funds Rate through early next year, with the short-term lending rate expected to peak around 4.25%. Just nine months ago, the Fed’s target was 0.00%-0.25%.
At the same time as raising short-term interest rates, the Fed ended its program of Quantitative Easing, the monetary policy used to stimulate activity in the aftermath of the 2008-2009 financial crisis and 2020’s COVID shutdown. When growth stalled as the pandemic spread, the Fed and other central banks injected cash into the global economy by buying government bonds other securities, and pushing interest rates to zero. When it became clear this year that the economy could be overheating, the Fed pivoted to slowing activity, and the disappearance of the largest buyer of US Treasuries and mortgage-backed securities helped to drive yields sharply higher.
The Fed began its new regime of tightening in March, and it takes roughly six months for the effects of monetary policy to ripple through the economy. Accordingly, the repercussions are now being felt. Short-term borrowing costs have soared, dampening demand for everything from home appliances and entertainment to automobiles and virtually anything else bought on credit. Prices for certain consumer goods and automobiles have begun to moderate, while gas prices have dropped. Longer term loans such as mortgages have doubled in cost from 3.25% to 6.5%. Already home sales have slowed, with sellers cutting prices, mortgage applications plunging, and new home construction slowing.
Thus far, the impact on overall consumer inflation has been negligible, obscured by rising food prices, wages and rents, and volatile energy costs.
Amid rising uncertainty and falling consumer confidence, financial markets continued to slide during the Third Quarter. For the year through September, the MSCI All-Country World Index was down 25.6%, with the broad US market only slightly better. Stocks in sectors like technology, healthcare and consumer goods decreased by 50% and more.
In addition, higher interest rates pushed bond prices sharply lower, with the Bloomberg US Aggregate Bond Index losing 14.6%. The strong dollar, which hurts American exporters, also worsened international investment returns. Non-US stock markets returned -15.8% in local currency terms but -26.2% when converted to US dollars.
Though our portfolios, like most, are down for the year, defensive moves made earlier in 2021 provided some measure of protection. While most socially responsible funds underperformed the market due to lack of exposure to energy and defense stocks, our allocations to value stocks, which fell less than large-cap growth companies, were helpful. Additionally, our hedged equity funds, which use options to limit their downside, dropped half as much as the main indices and buffered equity returns.
Shorter average maturities in our bond funds, which we positioned in this way due to our longstanding concerns about inflation, helped our fixed income portfolios avoid the worst of the bond market rout. Another notable holding is the PIMCO ESG Income fund, which did 5% better than the bond index through September.
More impactful still have been the Alternative Strategies funds, which we use on the conservative side of portfolios to mitigate the risk that rising interest rates will hurt traditional bond investments. We have increased allocations to Alternatives, which as a group outperformed the bond index by roughly 10%, helping to stabilize portfolios.
The coming winter will likely bring more challenges. The energy shock in Europe as Russia limits oil and gas supplies will worsen as weather grows colder. Ukraine continues to surprise with its fierce resistance, but Putin is capable of escalating the conflict exponentially.
Inflation remains persistent, and the Fed has communicated its intent to continue raising rates until it abates. Global manufacturing is slowing, and much of the world appears vulnerable to recession. And corporate profits, though still healthy, will be impacted by higher costs of capital, labor, and raw materials, combined with slowing sales.
Though job growth and wage gains remain strong for now, declining profit growth will likely affect hiring plans. Finally, the beneficial impact of Covid relief packages that put money in consumers’ pockets is fading. Those programs have ended with no new ones likely to pass a narrowly divided Congress.
We are nine months into the bear market, and losses across every asset class are rattling many investors. Nevertheless, we encourage you to hold tight, knowing that things will get better, that much of the downturn is already behind us, and that bear markets do not last forever.
As mentioned above, monetary policy operates with a six-month lag. As the ripple effect of tightening financial conditions spreads, and as global economic activity slows in response, inflation is likely to come down to more normal levels. Supply chain disruptions are resolving and goods are flowing more easily than last year, helping to reduce scarcity issues. Many retailers that had built up inventories are now cutting prices to move product. Peak inflation seems near at hand, and when consumer prices begin falling, the Fed is likely to back down from its hawkish posture. If this occurs, we will expect to see a decline in interest rates and a rally in bonds.
A lot of bad news has already been baked into security prices. After this year’s steep drops, many stocks are cheap by historical standards, particularly overseas. Bond yields as high as 4% on short term Treasuries are for the first time in many years offering real income. Markets could be vulnerable to further declines, but at some point, investors will start looking beyond inflation, high interest rates and recession, towards the coming recovery. And bear in mind that new bull markets usually begin well before economic data proves that the worst is over.
To wrap things up, we are happy to introduce Ernestina Savage, who joined LongView in September as Client Services Associate. Ernestina is a native Santa Fean and 2022 graduate of University of Puget Sound, with a double major in Political Science and History (magna cum laude). She’s working closely with Maria and completing a series of training programs encompassing Longview’s systems and software, as well as broad investment topics. We’re fortunate to have such a high caliber young person join our team. She looks forward to meeting you, whether in person or over the phone.
We appreciate your trust and welcome any questions you may have. Please call us if you would like to set up a time to talk. In the meantime, we wish you a beautiful Fall and holiday season, peace of mind, and good health.
The LongView Team