The late Jack Bogle, an investment industry titan and founder of The Vanguard Group, once declared that “the stock market is a giant distraction to the business of investing.” Equity prices, at any given time, reflect more than the value of the underlying businesses and shorter-term fluctuations are less critical for the investor with a longer-term horizon. That said, not every factor contributing to the current market downturn feels like merely a distraction. High inflation, rising interest rates, sluggish economic growth, regional energy scarcity, and the escalating conflict in Ukraine are all weighing heavily on prospects and sentiment. Comparatively, the U.S. remains strong, and we remain confident that our value-oriented discipline can weather the test over the long term as it faces a wide spectrum of market and economic conditions.
The U.S. equity market rally that kicked off the quarter sharply reversed course in mid-August resulting in negative returns for the past three months and exacerbating year-to-date declines. The S&P 500 closed on September 30th at 3,586 representing a return of -4.88% for the third quarter, and -23.86% for the first nine months of 2022. The Dow Jones Industrial Average (DJIA) ended September at 28,726 for a return of -6.16% in the past three months and -19.70% for the year to date.
There is no broad equity strategy, defined by capitalization size or value versus growth, which is in the green so far this year, although Large Cap Value, a significant focus of our managed portfolios here at Stolper Asset Management, holds the dubious distinction of being ‘least bad.’ Valuation of growth companies is more interest rate sensitive and, in general, there has been a retrenchment towards fairly valued, quality names in currently favored industries. Year-to-date, energy remains the standout sector, up over 35%, although WTI Crude oil is now around $83 / barrel, down considerably from the 2022 peaks above $120 / barrel in March and June.
A major factor driving the market reversal during the quarter was August’s inflation numbers, which came in hotter than many expected, causing a ‘panic over the print.’ Although the Consumer Price Index (CPI) year-on-year increase of 8.3% in August 2022 was the lowest in four months, it was still above market forecasts of 8.1%. Additionally, core CPI, excluding the more volatile food and energy sectors, rose to 6.3% annually, indicative of systemic rising prices. The day the figures were released, on September 13th, the S&P 500 sank 4.3%, its worst day since March 2020, and the downward trajectory has continued.
For financial markets, with the current hyper-focus on inflation, all eyes remain on the Federal Reserve and how aggressively the central bank is prepared to tighten. Fed Chair, Jerome Powell, has not minced words. At the Jackson Hole Symposium in August, Powell reiterated the commitment to continue fighting the hottest inflation in decades “until the job is done,” acknowledging that the economy would experience “some pain” and Fed actions could hurt the strong job market. The message was that allowing faster inflation expectations to set in would be more harmful.
On the back of the August inflation print, few were therefore surprised when the Federal Open Market Committee (FOMC) announced its third consecutive 0.75% rate hike on September 21st. Its new target range is now 3.00 – 3.25%, the highest since 2008. Perhaps a more sobering message for markets was the Committee’s adjusted forecast for a 2023 terminal rate, or potential peak. The figure jumped to 4.6%, well into restrictive territory, and broadcasting more hikes to come.
U.S. Federal Government debt recently eclipsed $30 trillion for the first time, with the fiscal burden of the pandemic accelerating what was already widely considered an unsustainable trajectory. How much this debt costs, nominally and as a share of GDP, is highly sensitive to interest rates. While the Fed sets short-term rates, the rates for all maturities are affected. The 10-year Treasury note, now at 3.74%, and having briefly topped 4.00%, is at its highest yield since April 2010, and the more policy-sensitive 2-year Treasury reached 4.35% or the highest level since August 2007. This has put pressure on bond prices, which are inversely correlated with yield, causing pain for fixed income investors as Treasuries remain headed for their biggest annual loss since the 1970s.
On the economic front, consensus U.S. 2022 growth estimates have fallen from 3.9% at the start of the year to 1.8% now. For 2023, the consensus is currently at 1.1%, although Raymond James is more cautious, putting the figure at -0.5%, due to the restrictive consequences of a prolonged higher Fed Funds rate and the lagged effect of the current tightening policy. Real gross domestic product (GDP) decreased at an annual rate of 0.6% in the second quarter of 2022. Consequently, Raymond James’ base case for the U.S. economy forecasts a mild recession beginning at the end of this year and lasting through the first three quarters of 2023.
More interest-sensitive sectors of the economy, such as the housing market, are already exhibiting signs of a slowdown. For the first time since 2008, the 30-year fixed mortgage rate has ballooned to 6.7%, more than double from a year ago, and building permits have declined sharply hitting their lowest levels since June 2020. Housing contraction, which has a knock-on effect on income and spending in certain sectors, is not positive for GDP growth, but a protracted cooling off of the market could bring down shelter costs, a persistently high inflation component. Already, in August, apartment rents fell month-on-month nationally for the first time in nearly two years, although the 0.1% decline is modest compared to the 23% overall increase in rent since August 2020.
Rising interest rates, coupled with the relative health of our economy, are domestic factors contributing to the unabated rise in the value of the U.S. dollar over the past year, although economic woes abroad are also drivers. The U.S. Dollar Index (DXY), a measure of the value of the dollar relative to a basket of foreign currencies, is currently close to 112 having surged to its highest level since 2002. The euro, having dipped below parity against the U.S. dollar in July for the first time since 2002, has since slumped further. The Japanese Yen is at its weakest level since 1998 and, perhaps most dramatically, the U.K.’s struggling pound hit its lowest level ever against the U.S. dollar going into the final week of the quarter.
A strengthening dollar makes U.S. imports more expensive for foreigners (hurting American exporters and U.S. companies with multinational operations) and is especially painful for countries and organizations with dollar-denominated debt also hit by rising rates, and for those relying on energy imports priced in dollars. The added cost pressures are unwelcome with inflation already at critically high levels for many of the largest economies worldwide. Concern over the prospect of stagflation, defined as persistent high inflation coinciding with stagnant demand, is rising.
Foreign leaders and policymakers have been making bold moves. Liz Truss, who replaced Boris Johnson in September as the U.K.’s fourth Prime Minister in six years, has unveiled her government’s plans for big tax cuts and new spending to bolster the nation’s beleaguered economy and offset rising energy costs. With consumer price inflation already at 9.9% year-on-year for August, the fear is that such fiscal policies will exacerbate price hikes, reduce government income while increasing borrowing costs, and further weaken the pound.
On September 26th, the Bank of England (BoE) stated it “will not hesitate” to raise interest rates as much as required to hit its 2% inflation target. In response, the one-year gilt yield rose over half a percentage point to close at 4.13%, one of the largest single-day moves on record. Subsequently, the BoE dramatically intervened and said it would buy long maturity U.K. government bonds “on whatever scale is necessary” to try to restore order to the market. The BoE has recently hiked its base rate to 2.25% from 1.75%, joining a slew of other central banks, including those of Sweden and Switzerland, taking similar measures at the same time. With Euro-area inflation nearing 10%, the European Central Bank (ECB) announced a historic 0.75% hike earlier in September, taking its benchmark rate to 0.75%. ECB President Christine Lagarde has since telegraphed future raises even with economic activity expected to “slow substantially.”
The People’s Bank of China and The Bank of Japan (BOJ) remain outliers amid this coordinated tightening. The Chinese Renminbi has fallen 11.5% against the dollar this year, despite new government support measures, as the Fed raises rates here. And with the Japanese yen falling over 20% this year and yields rising, the BOJ has intervened in other ways including buying JGBs (government bonds) to drive yields lower and, for the first time in twenty-four years, allocating large sums (reportedly $3 trillion yen or $21 billion) to buy yen and sell the U.S. dollar.
Aside from the unprecedented levels of government stimulus deployed during the most acute phases of the COVID pandemic and initial economic rebounds on the back of shutdowns, an unfolding energy squeeze is also underpinning worldwide inflationary pressures. The rise in fuel costs was driving inflation up in many countries even before Russia invaded Ukraine. Now, despite years-long efforts to reduce reliance on Russian resources, energy-dependent Europe finds itself in a potential stranglehold as it fears for its natural gas supply over the coming quarters. As we write, the North Atlantic Treaty Organization (NATO) is condemning what it has determined was the deliberate sabotage of Russian Nord Stream gas pipelines, now causing major leaks into the Baltic Sea. On a positive note, LNG (liquid natural gas) imports have helped displace capacity sourced from Russia, and EU storage is 86% full, on average. It should be noted, however, that the percentage of storage capacity filled does not equate to the percentage of energy needs preemptively met. New energy flows, in addition to storage, are still required.
A recent signal of the severity of the situation was the nationalization by the German government of Uniper, a major utility and Germany’s largest gas importer, which was already financially strained and unable to survive current conditions independently. Shockingly, Germany’s August Producer Price Index (PPI) data showed a 45.8% year-on-year increase, largely due to energy price surges. In general, exorbitant costs cannot be absorbed by industry, businesses, and households without government subsidies or abrupt about turns in sanctions and embargos. While North America and Western Europe continue to take a hard stance against Russian energy, India, China, and several other nations are taking the opportunity to increase oil and gas imports from Russia at lower costs to improve their own energy security.
In India, Prime Minister Modi has called for “diplomacy and dialogue” over the war in Ukraine, while the country’s petroleum minister stated “I have a moral duty to my consumer,” also saying he did not “want a situation where the petrol pumps run dry.” Russian President Vladimir Putin, meeting in mid-September with China’s President Xi, on Xi’s first trip since the COVID pandemic, praised China’s “balanced” position on the conflict in Ukraine. Against such a backdrop, it is hard to envisage how a price cap on Russian oil that is being pushed by G7 countries will garner broad worldwide support. Such a cap was proposed to coincide with the EU’s ban on seaborne Russian oil imports that will take effect in December.
The war in Ukraine wages on, with Russia encountering military setbacks recently, although upping its level of aggression with Putin’s September announcement of partial mobilization, calling up reservists. Russia is also beginning to release the results of referendums billed as the first formal step in the annexation of four Russian-occupied Ukrainian regions. Installed officials are claiming overwhelming support for becoming part of Russia, while Ukraine and the West are denouncing the voting process as a coercive sham. Economically, the Bank of Russia cut rates by 0.5% in September to 7.5%, and the ruble has rallied nearly 40% since its collapse following Russia’s February invasion of Ukraine. In a recent speech, Putin proclaimed “the economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets.”
In the U.S., voting in midterm elections on November 8th is fast approaching. At the halfway point between presidential elections, the incumbent party routinely fares poorly. President Biden’s slumping approval ratings (51% disapproval according to the latest Economist / YouGov polls) do not favor the Democratic Party, with the economy heavily weighted as the leading concern. Democrats have, however, notched up some recent legislative achievements, including the optimistically-named Inflation Reduction Act and the cancellation of a portion of student debt. As part of an effort to keep fuel prices low, with the number at the pump proving a political flash point, Biden has chosen to drain the Strategic Petroleum Reserve (SPR) to its lowest level since 1984. It remains to be seen if his party can muster sufficient support to maintain control of both, or either, the House and Senate.
We hope you are enjoying the beautiful season of fall, and we hope that the coming months bring a mild winter and the prospect of peace to those who need it most. As always, and during these trying market conditions, we thank you for the continued confidence you place in us as your trusted financial advisor.
The S&P 500 is an unmanaged index of 500 widely held companies and over 80% of the U.S. equities market. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow”, is an index representing 30 companies maintained and reviewed by the editors of the Wall Street Journal. The information contained in this report does not purport to be a complete description of the securities, markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the investment adviser representatives of Stolper Asset Management and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you can lose principal. There is no assurance any strategy will be successful. There is no guarantee that any forecasts made will come to pass. Past performance may not be indicative of future results. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Dividends are not guaranteed and must be authorized by the company’s board of directors.