The third quarter of 2022 started strong but ultimately was another poor quarter for investments across the board. After recovering as much as 13.94% through mid-August, the S&P 500 ended the quarter down 4.89%. Inflation continued to run high but did ease from the over 9% level seen in June. The optimism that the slowing inflation readings spurred quickly faded in the wake of Jerome Powell’s speech at Jackson Hole at the end of August, where he bluntly stated that the Fed would not be slowing the pace of their rate hikes until inflation receded further. The Fed hiked rates by 0.75% in each of their meetings during the quarter. Consumer discretionary and energy were the only sectors higher, while technology was the biggest laggard. Growth outpaced value, as the early quarter rebound in equities was more pronounced in growth sectors. Multinational companies struggled as the U.S. dollar surged against foreign currencies, hurting companies with international operations due to exchange rates taking a bite out of profits earned abroad.
International equities trailed domestic equities in the quarter. The MSCI EAFE Index ended the quarter down 9.26% as central banks around the world raced to catch up to the Fed’s rate increases. Currencies globally depreciated against the dollar, causing inflation worldwide to rise as dollar-denominated goods became more expensive relative to local currencies. Further, Russia intensified its efforts in Ukraine amid losing territories it had captured early in the war, instituting a draft to ramp up manpower. Emerging markets also saw another quarter of double-digit losses on the back of a strengthening U.S. dollar.
Fixed income essentially matched U.S. equities with the Bloomberg U.S. Aggregate Bond Index ending down 4.75%. The Fed kept at their aggressive rate hiking schedule to try and combat inflation. The result was a continued climb in bond yields, especially in shorter maturity issues, with the U.S. 2 Year Treasury yield topping 4% for the first time since 2007. The Fed’s balance sheet continued to contract, dropping to its lowest level since December 2021. The Fed has made it clear that they will not slow down their tightening process until inflation is within an acceptable range, even if it means the economy suffers near-term pain.
With domestic equities near their lows of the year, opportunity remains for investors looking for long-term upside. Even with an expected slowdown in earnings, consensus expectations are for growth of about 2.4% for the third quarter. On top of this, interest coverage ratios are hovering around pre-pandemic levels, meaning companies are still positioned well financially. While the sharp interest rate increases will impact earnings in the coming months, many of the higher-quality areas of the market look oversold. Looking long-term, we believe more opportunity exists for profit-making companies rather than the unprofitable growth names that thrived under the easy monetary conditions of the last few years.
On the fixed income front, we are looking for the Fed to continue its rate hikes through at least the end of the year. While fixed income has had an exceptionally rough year, yields are now at their highest level since 2007, creating an entry point for investors to pick up attractive yields. Further, inflation is seeing some signs of easing, as the readings for July, August, and September came in at decelerating levels. This is an especially encouraging sign, given the unemployment rate remains at its pre-pandemic lows.
The U.S. economy continues to show signs of the Federal Reserve tightening doing its job. For the first time since 2018, home prices saw a decline month-over-month in July. Job openings fell to their lowest level since June last year. Retailers have seen supply gluts rather than shortages, prompting widespread sales. Gas prices fell almost every day in the third quarter. Inflation has stuck around for longer than the Federal Reserve had anticipated but has begun rolling over and should continue to ease moving forward as the lagging effects of the Fed’s rate hikes start to impact the economy. Consumers generally agree that inflation will continue to slow as forward inflation expectations, a driver of inflation, have fallen to their lowest level of 2022.
Despite the slowing of several indicators that provide insight into what inflation and the economy may look like going forward, the labor market remains resilient. Job openings, while falling, remain well above pre-pandemic levels, and unemployment is sitting around pre-pandemic lows, a generally good sign for the economy. The decline in job openings is a positive for the Fed as they look to cool the job market a bit to help its fight against inflation, while the low level of unemployment gives hope that a recession may be avoidable. It is important to note that if the economy ends up in a recession, it is likely to be shallow. Relatively low debt levels, strong interest coverage ratios, and higher levels of savings than pre-pandemic combine to leave consumers and corporations alike well-positioned financially.
Despite ongoing uncertainty surrounding Federal Reserve tightening, inflation, and geopolitical tensions, we remain cautiously optimistic. Valuations on equities are attractive, and in the fixed income space, meaningful yields can be found for the first time in a long time. With the sell-off this year being so unpleasant, keeping a long-term perspective is more important than ever. Markets have recovered from every sell-off they have endured before, and each drop creates a new opportunity that rewards investors who maintain a long-term outlook consistent with their investing goals. We continue to search for bargains throughout the market volatility and, in the meantime, are taking steps such as tax-loss harvesting to keep our clients best positioned for whatever the future may hold.