My F&M

Market Update

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The bear market for stocks resumed in the third quarter and recently extended market lows.  By one measure - the time the stock market has remained below its 200-day average - this has been the longest-lasting stock decline since 2009. 

In our last update, we did not paint a rosy picture.  Since the end of the second quarter, stock indexes declined about 5% more while bonds are down only slightly less.  Aside from slight improvements in stock valuations and significantly higher bond yields, the economic picture is little changed: inflation remains high, economic growth still appears to sputter near a stall, and the Federal Reserve continues to tighten.  In other words, in the last quarter, there has been a little more discounting but very little dissipation of risk.

In the latest inflation report, CPI annual growth was 8.3% - slightly moderated from its recent peak of 9.1%.  More troubling was that “core inflation” which excludes the more volatile energy and food components, rose 6.3% in the past year.  Some commodity prices have softened recently, and with 30-year mortgage rates well over 6%, the Case-Shiller home price index fell 0.8% in the most recent month, its largest monthly decline in a decade.  Flat or declining home prices will eventually exert downward pressure on inflation, but home price impact on the CPI’s “imputed rent” component takes time to work through the index. 

In the meantime, the Federal Reserve seeks to reduce aggregate demand with higher interest rates, and it recently signaled higher rates ahead than markets previously anticipated.  This rapid rise in US bond rates has attracted foreign investment, driving up the value of the dollar against foreign currencies. 

Low interest rates weren’t the only cause of this highest bout of inflation in 40 years, so high interest rates alone seem unlikely to be the sole solution.  Still, the Fed is likely to continue to raise rates at least until they are higher than “core inflation” and then to hold them there until either inflation moderates or some financial crisis arises.

The Fed is also in “quantitative tightening” mode, which means it is shrinking its holdings of bonds (its “balance sheet”) and ultimately, the money supply.  This started in a small way in March but began in earnest last month.  As an exploding money supply in 2020 associated with COVID stimulus spending preceded this inflation, a shrinking money supply should eventually reign it in, but with “long and irregular” lags.  The full effect of this may not be evident until late next year.

Perhaps the largest change in the risk outlook in the past quarter is the heightened risk of a financial “accident” somewhere.  Each time interest rates have risen this rapidly or currencies have fallen this quickly against the dollar, some sort of financial stress appeared that caused market disruptions.  The Fed has now raised its benchmark interest rate faster than at any other time in modern financial history (faster than each of the last five Fed tightening cycles going back to the late 1980s).  This time may be different and a financial crisis of some sort may be averted, but even as we can’t predict this, we don’t see why that would be expected.

Beyond the Fed and purely economic developments, shifts in geopolitics have also raised risks.  Ukraine’s recent successes in pushing back Russian aggression are welcome in many ways, but they don’t make the world safer as a failing tyrant with nuclear weapons is painted into a tighter corner and appears to see no options other than escalation.  On 9/21, Putin said, “Russia will use all the instruments at its disposal to counter a threat against its territorial integrity – this is not a bluff”, and on 9/29, he declared portions of Ukraine to be a part of Russia through “annexation”.  In Asia, China recently escalated threatening words and actions against Taiwan as our administration publicly broke its policy of “strategic ambiguity” and pledged we would defend the island.  After Xi’s expected appointment for life this month, might he consider he has a freer hand?

Farther ahead, bond guru Jeffrey Gundlach recently posited that since the Fed intended to increase inflation a little and overshot a lot, why should we not expect it to eventually overshoot on the downside as well and eventually reduce inflation not just to 2%, but perhaps to -2% or so – a condition that only occurs during severe economic stress. 

As always, markets are keenly focused on what the Fed does, and the Fed is keenly focused on inflation.  Recent Fed comments imply it expects inflation to significantly moderate next year.  We hope that’s right, but we note that when inflation last exceeded 5% in the 1990s, it took several years to get it down to the Fed’s target.

Moreover, globalization helped suppress inflation for years but going forward, a decline in globalization is increasingly likely, which may elevate inflation.  It’s also probable an accelerated move away from cheap fossil fuels to other energy sources may exacerbate inflation.  What may be good for the environment may be more costly for the economy.

Prior to these recent declines, markets were quite expensive.  Much of that over-valuation has since been corrected but markets do not yet appear to account for lower earnings associated with a likely recession.  We may or may not be in a recession now, and if so, it’s an odd one with a very tight labor market.  But risks of a recession ahead have grown and if we get one, it seems likely markets may have more downside, though, of course, we can’t know.  And particularly uncertain is how severe the next recession may be.

Pulling all this together, even though the return of the US stock market as measured by the Russell 3000 Index is nearly -25% this year so far, with foreign stocks a bit worse, and the return of the most widely followed bond index being -14.6% this year to date, it appears unlikely that markets represent unusually good opportunities yet.  Of course, we are now one quarter closer to the bottom, whenever it may be than we were three months ago (if that hasn’t already occurred). 

This current state of market malaise and economic headwinds will not be the permanent state of affairs and will certainly, eventually pass.  Until then, we’re pleased that market risk hedges have been performing well, our short maturities and extraordinary diversification in bond portfolios have greatly helped, and the stock market has made a long overdue shift to favoring value stocks, and each of these have cushioned managed portfolios in this difficult environment.  Portfolio income has held up well this year and, in many cases, has grown.  And for the first time in years, as bonds mature, we are increasingly able to replace them with bonds that pay more income rather than less. 

After so many years of zero money fund interest rates, very low bond yields, and expensive stocks, the prospect of higher future returns for all asset classes after current inflation and economic storms pass is something we will all welcome.