as of September 30, 2022
It was another difficult quarter for both stocks and bonds as global markets continued their downtrend in the third quarter. Federal Reserve Chair Powell’s speech at Jackson Hole in August dashed hopes that the Fed would consider pausing its tightening cycle. After recovering in July, both equity and bond markets broke through June lows. As a result of hawkish Fed guidance, bond markets ratcheted up expectations for this cycle’s terminal interest rate from 3.25% at the end of July to 4.5%. The drawdown in stocks and bonds this year appears to be a reasonable response to the shift in Fed policy to combat inflation and the resulting uncertainty for economic growth. The decline in equities can be explained by the rise in interest rates putting downward pressure on valuations. The outlook for inflation and its impact on Fed policy likely will remain the key driver of the markets’ direction.
Encouragingly, inflationary pressures appear to be easing. The decline in energy prices in the US from their peaks should lead the headline inflation rate lower in the coming months. The gradual easing of supply side constraints and weaker demand could also slow core inflation. Easing inflation could mean that Fed hawkishness is near the peak. US economic activity has been nearly flat in 2022 and the tightening of financial conditions is only just beginning to be felt. The drag likely will intensify into 2023, increasing the risk of at least a mild recession. The good news is that household balance sheets remain strong, which should cushion household spending and prevent a deep downturn.
Global equities posted another quarter of declines in Q3, with the MSCI ACWI index, a measure of global equities, falling 6.8% during the quarter. Year-to-date, the index has declined 27.1%. The S&P 500 fell 4.9% during the quarter, and is now down 23.9% year-to-date. International developed stocks declined 9.4% in Q3, leaving their year-to-date decline at 23.9%. A stronger dollar detracted 5.8% from US dollar returns during the quarter. Emerging market equities fell 11.6% in Q3 and 27.2% year-to-date.
Within fixed income, interest rates continued to weigh on returns. The Bloomberg Aggregate index declined 4.8% during the quarter. Treasuries declined 4.3%, but outperformed corporate bonds, which declined 5.1%. The yield curve shifted higher and flattened, with 3-month yields rising 161 basis points, while 30-year yields rose by 65 basis points.
Real estate investment trusts (REITs) fell roughly 11% during Q3, faring worse than broader equity markets. Infrastructure stocks declined 9% during the quarter, but they have outperformed broader markets year-to-date. Commodities and natural resource stocks posted modest declines during the month on fears of a global slowdown, but returns remain positive year-to-date.
Looking ahead, a mild recession that reduces inflation could prove supportive of both stock and bond markets. The prospect of the Fed halting rate increases and a fall in longer-term interest rates could more than offset the negative impact of weak earnings for equities in a mild recession. The biggest downside risk we see is if inflation remains sticky even as the economy slows. This could require a more forceful Fed response and a deeper recession. This likely would result in continued weakness in stocks and bonds.
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