, ,

The Brave Report: Market Commentary for October 2022

Click here for .pdf version of this report: The Brave Report-October 2022

Let’s all take a deep breath…. Over the last few months (and pretty much since the start of the year) it has been very painful to look at our account balances.  Without a strong rally into year-end, we are shaping up to have one of the worst years in the markets that we have seen in quite some time. However, it is important to point out that this is on the heels of three straight great years. The downward pressures on the markets and the economy are real and until we start to see some downward movement in inflation, these pressures will continue. When this dust finally settles, I think there will be some great opportunities since valuations of very profitable companies have been compressed, but we are not there yet.

Market Overview

Over the month of September, all major indices dropped sharply.  The S&P 500 lost 9.3% the Dow dropped by 8.8% and the NASDAQ was down over 10%.  While the quarter had started strong with the markets up in July and August, this September drop led to another losing quarter. The S&P and the Dow ended the third quarter down 5.2% and 6.6% respectively.  The NASDAQ only dropped 4.1% marking a reversal from previous quarters when the NASDAQ underperformed.  This leaves the three major indices in bear market territory heading into the fourth quarter. If S&P were to close the year where it is today it would mark the worst year since the financial crisis and the third worst year since 1974. Albeit this is coming after a run of three great years when the S&P was up 28%, 16% and 26% going back to 2019.

While the equity markets made a large move to the downside, the more pronounced moves have been on the fixed-income side.  Rates continued the climb that started at the beginning of August and jumped sharply across the board. The 10-year treasury peaked just shy of 4%, its highest level since 2010.  It has now risen almost 150 basis points since early August.  On the shorter end of the curve, we saw the 2-year treasury jump above 4% for the first time since 2007.  The markets have priced in continued aggressive action from the Fed but at the same time have made the fixed-income space a lot more attractive from an investment standpoint. With a lot of uncertainty expected in the coming months, getting paid more than 4% for the next 1-3 years seems appetizing and increasing fixed-income allocations may help investors weather the storm. Additionally, if the Fed softens its stance, we could also capture some positive price movement as rates drop.

 

All major indices are in bear market territory, inflation continues to come in hot and rates seem to rise every day. Equities are dropping along with bond prices, muting traditional diversification benefits. You also can’t just hide in cash because that cash is losing money to inflation. Everywhere you look, there is bad news, and every financial pundit out there is beating the drum of recession. So, the world must be ending soon?

In times like these, perspective is very important. Especially for the long-term investor.  Let me rephrase that last paragraph:  Over the past two and a half years the world has been gripped by a global pandemic that has closed borders, kept people from going to work and killed millions of people. Russia invaded another sovereign country, cutting off supplies of oil and gas to large portions of Europe and driving energy prices through the roof. And, our relationship with our biggest global economic and military competitor, China, has continued to deteriorate. Yet, as of the end of the 3rd quarter, the S&P 500 is still up more than 20% over the last 3 years, and up more than 60% from the pandemic lows.  Over the last 10 years, the S&P 500 has more than tripled. Perspective matters.

Now, I am not saying this to downplay what is going on in the economy today.  The issues are very real.  Inflation is a major problem.  The Fed response has been flawed. There are parts of the economy that are probably already in a recession and that could spill over to the rest of the economy. Because of this, the markets have reacted sharply to the downside.  Whether they have reacted correctly is what is still to be determined. These types of determinations play out over the long run, not the short. The patient investor can capitalize on that.

The stock market is a forward-looking indicator, which means it will normally move in anticipation of data and then correct itself if it was wrong.  This happens in both directions.  We saw it overreact to the upside last year as the consensus was that inflation would be transitory.  As inflation persisted, the Fed and the market realized they had been wrong so needed to correct.  The ripple effects of this have exposed or caused other cracks in the economy, exacerbating the situation. So, where are we today and what needs to happen to stabilize or reverse the markets?

The big elephant in the room that seems to be driving most of this is inflation.  The Fed along with other international central banks let inflation get out of control. While I think their initial assessment that inflation would be transitory was correct, too many external shocks forced inflation higher and made it stickier. China’s continued commitment to its COVID Zero policy forced disruptions to supply chains.  Companies can’t just shift production and distribution on a dime.  With products in short supply, prices can only go up.  On top of this, the Russian invasion of Ukraine then sent energy and other chemical prices through the roof.  These increases trickle through the entire economy and caused a wide rise in prices across many industries.

With inflation now running hot for quite some time, the Fed is left in a precarious position to put the genie back in the bottle. So far, their answer has been to raise interest rates faster than at any time in history and have signaled that this will continue. Their job is not an easy one.  They are raising rates in an attempt to put small cracks in the economy and slow it down, but not enough cracks that it breaks. In other words, they are trying to slow the economy enough to weaken the historically strong job market and bring down inflation without doing enough damage that the economy falls into a deep prolonged recession.

Outside analysts and investors are falling into three groups as they try to predict how this is going to play out and how successful the Fed will be:

The first group continues to beat the drum that the Fed isn’t acting fast enough and needs to continue to aggressively raise rates to bring inflation down, either in one big increase (the rip the band-aid crowd) or continued aggressive increases over the next year. They feel that if the Fed fails to bring inflation under control it will create larger negative economic impacts. With economic and labor data continuing to come out strong there is the thinking that the economy can withstand a more aggressive Fed. The risk to this is that the Fed goes too far too fast and sends the economy into a recession that could have been avoided.

The second group thinks that the Fed is moving too fast and that the impacts of the last few rate hikes haven’t worked their way into the economy yet. An increase in rates doesn’t have an immediate impact on the economy and it takes time to understand its impact.  This group also thinks that natural economic forces will work to bring inflation into check. They think that while this inflation wasn’t transitory, as the Fed had described it last year, it will still fall off due to the alleviation of some of the outside factors that are causing it. This process is taking longer than initially anticipated but it will still happen.

The last group is the smallest group. They think the Fed will be able to thread the needle and bring down inflation without weakening the economy too much. They won’t raise rates too fast and will be able to slow their hikes as the natural economic forces also help to bring down inflation. This is the soft landing.

With this many schools of thought, it is no wonder that we have seen the markets sell-off. Markets hate this kind of uncertainty. I also don’t envy the Fed in this situation.  While quite a bit of blame is being put on the Fed for contributing to this problem, that blame doesn’t help them navigate out of it. Inflation data is backward-looking, and their rate increases take time to trickle into the economy. So, they are using backward-looking data to make decisions that won’t impact the economy for months to come and then have to make another decision before the impact of their first decision has been felt. All while external shocks, that are out of their control, seem to pop up each day. This is no easy task.

With all of these uncertainties, what are we watching to determine when markets are going to stabilize? Outside of just looking at top-line inflation data, I am looking for any signs that these non-Fed-related forces are softening inflation on their own. This would help to inform what path the Fed might take. It would be a signal that they don’t need to bring inflation down on their own.

On the large scale, this would mean some sort of resolution or path to resolution in Ukraine or the reduction of COVID restrictions in China. On a smaller scale, this would mean signs that supply chain issues are abating. We already have seen some small signs that this is happening. There have been some recent reports that the backlog of cargo ships on the west coast has drastically fallen, with some ships starting to come over with empty containers.  This would show a decrease in demand and an alleviation of some of the supply glut. Another example of this is that companies (like Nike last week) are starting to report large backlogs of inventory.  This means that they will need to cut prices to clear this inventory. This would put downward pressure on inflation heading into the holiday season.

The upcoming earnings season will be very informative as it will give us a glimpse into what is going on under the economy’s surface. This will give us a clearer picture of the current demand picture and if companies are still dealing with supply chain issues. We will also be able to see how the current rate increases have impacted earnings so far.  The markets will focus a lot on company guidance, and this could cause a headwind for stocks. With so many uncertainties I expect guidance to be cautious across the board, which is normally not good for stocks.

The paradox we are currently in around earnings is that if company data and guidance show that the economy is slowing, it could signal that the Fed can slow their rate hikes, and this could cause markets to go up. On the flip side, if earnings and guidance come out much better than expected, it could be a sign that the economy can handle a more aggressive Fed and this, albeit counterintuitive to what should happen in a normal market, could send stocks down.

Lastly, for the markets to really reverse we will need to see a change in sentiment across the market. The market is very oversold in some areas and sentiment is very negative.  This is normally a contrarian indicator and a sign we are near a bottom but so far this has only caused a few oversold one or two-day bounces that traders seem to be selling into.  Until one of these bounces can be seen as a buying opportunity then we will be range bound to the upside.

I am still optimistic over the long run and cautiously optimistic over the medium term. If you are a long-term investor with no short-term capital needs, then you just have to take a deep breath and stay the course.  But, on the short term I think this volatility will continue for the next 6-12 months or until we start to see sentiment change in a meaningful way.  If inflation data starts to drop, this perspective will change but for the time being, I am going to be patient and look to add to some fixed-income positions on the short side of the curve and to equity positions only when the right opportunity presents itself. I do not think there is a rush to chase the relief rallies when they happen, yet.

Strategy Commentary

As discussed, I expect volatility to continue for the foreseeable future.  I continue to caution against any large-scale changes to portfolios in this environment.  It is important to continue to monitor your overall allocations to make sure they are in line with your long-term risk tolerance.  As we approach year-end there may be some opportunities to harvest some losses but in doing so it is important to not let your portfolio drift too much. There will be opportunities coming out of this so I will be using this time to identify quality names and sectors that will benefit as inflation subsides and rates steady.

On the domestic side, a lot of damage has already been done, especially in the technology, communication services and consumer discretionary sectors. However, when inflation starts to wane and rates stabilize or drop, these will be the sectors to rally.  I would not try to chase the high-flying names in these sectors but look to the quality names if I am going to add. The defensive sectors have been helping to weather the storm and should continue to do so. Energy continues to be the only sector in positive territory for the year and this should continue as OPEC continues to cut production and the Ukraine conflict persists.  These defensive names are a good place to hide until the storm is over, but these sectors will underperform if the markets turn around. With any clients looking to put new money into equity I am recommending a bar belled approach with some defensives but also some names that could benefit from a recovery.

On the international side, I have been trimming positions and am moving toward being underweight in these areas.  The Ukraine crisis could cause an energy crunch in Europe as we move through the winter and this will create a drag on all Eurozone economies. The strengthening dollar will also cause a headwind for developed and developing countries around the world.  These economies are also dealing with inflation, but the strong dollar is causing even more pressure.  For now, I am reducing exposure.

On the fixed income side, my perspective has completely changed.  I have been underweight fixed income for a few years now and have increased cash allocations as a replacement. With rates rising rapidly I have been becoming more bullish over the last few months and have been adding to positions.  A majority of this exposure has been on the short end of the curve.  I am also recommending clients park some of their excess cash in short-dated treasuries to try to at least keep up with inflation and ride through the volatility. Rates may still rise more but I think we are closer to the top of the range than the bottom which creates an attractive buying opportunity over the next few months.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *