This article is brought to you in collaboration with our colleagues at Laird Norton Wealth Management from their post, Economic Flash: Equity Markets Rally on the Hopes of Good News from the Fed.
U.S. Economy: Is There a Recession Under the Hood?
The U.S. economy returned to growth based on the first release of Q3 GDP, which surpassed expectations at a 2.6% annual rate. However, a look under the hood shows most of that was driven by exports and inventories while the contribution of consumption weakened. Also, stubbornly high inflation (8.2% YoY CPI in September) with a backdrop of falling corporate earnings forecasts, combined with already weaker real estate, manufacturing and labor market data, all point to a rockier road ahead.
U.S. Stocks: Halloween Rebound
On the heels of one of the more difficult months in recent memory, U.S. equities posted their second-strongest month of 2022 with a late October rally. Hopes the Fed would slow its pace of interest rate hikes, stocks appearing oversold based on technical indicators, and relative resiliency in economic data were at the root. Energy (+69% YTD) was far and away the strongest sector, with rising oil and gasoline prices driving a 25% return.
Foreign Stocks: A Tale of Two Markets
Non-U.S. equity performance was bifurcated between advanced and emerging economies, with the former less impacted by idiosyncratic issues. The U.S. dollar wasn’t as much of a headwind, as a weaker yen continues to plague Japan, renewed COVID shutdowns in China and uncertainty around the presidential election in Brazil prevented more positive returns for both asset classes.
Fixed Income: High Yield Bonds Follow Equities Upward
The yield of the 10-year U.S. Treasury has risen nearly 2.5% in the last year and settled near 4.1% in October, meaning core fixed income positions such as mortgages and municipal bonds have struggled. With a recession looming, it may be surprising that high yield bonds outperformed, but their relatively short duration limited the effects of interest rate increases and investors expect corporate defaults to be low, especially in energy which is a large component of the high yield market.
Real Assets: Public vs. Private Real Estate
Real assets in October generally benefited from the incremental improvement in economic sentiment. Year-to-date performance is disparate across market segments: public REITs have fallen nearly 26%, whereas many private real estate investments have posted gains. Private structures may have different mandates, use less leverage and face less liquidation pressure, but with other “risk assets” broadly in the red, it would be fair to expect some cooling in the private markets.
Alternatives: Non-traditional Investments Still Diversifying
Semi-liquid alternatives such as hedge funds didn’t do much better than tread water in October but have been modestly accretive to portfolios this year. Still, with public markets dislocated in varying degrees amid persistently above-average volatility, the opportunity set for both semi-liquid and illiquid alternatives makes for a compelling time to establish long-term strategic positions.
Equities Total Returns
Fixed Income Total Returns
All eyes have remained on the Federal Reserve through early November, with sentiment regarding its approach to tightening market liquidity and monetary policy arguably still the most important factor in markets. Every economic data point is considered through the lens of what it will mean for Fed policy after more than one member of the FOMC has offered up that the Fed was willing to inflict some measure of “pain” on the economy to rein in inflation. That isn’t to say that the Fed wants to push the economy into a deep recession. In fact, over the last few weeks, pundits and Fed watchers had started to see an even chance that the latest economic data would give the Fed a reason to slow down the Fed funds rate hikes. That said, after another 0.75% rate increase in November, the committee might seem to be following through on their promise of pain. However, sometimes the accompanying statement to a rate decision is more telling than the magnitude of the move itself: In that statement, Fed Chair Jerome Powell offered mixed messages that suggested both a future reassessment and that there is “still a ways to go.”
Slightly less discussed is that Fed policy has been a key factor in the recent strength of the U.S. dollar, which has had a meaningful impact on both financial markets and the global economy. If the Fed keeps their head down with this quicker pace than other developed economies, the dollar will continue to look relatively more attractive. With net exports being the driver of third quarter U.S. GDP growth, a stronger U.S. dollar would be another headwind to consider in quarters ahead. Additionally, it would continue to detract from results from foreign investments for U.S. investors. Other factors could boost the dollar, including if some other form of market or economic uncertainty strikes us, such as a resumed trade war with China or further escalation in the Ukraine/Russia conflict. Still, if history is a guide, the dollar is on par with peaks we haven’t seen in 20 years, and those proved to be short lived.
With the market volatility we have experienced, it is understandable to feel like dramatic changes need to be made in portfolios. Resisting that temptation can be an important part of achieving your long-term objectives. Big “down days” in volatile periods are often followed by big “up days,” and missing even the ten best days over a long time horizon can have a material effect on your compounded wealth. That doesn’t mean there are no actions to be taken. We continue to rebalance and are making manager adjustments within asset classes to consolidate our best ideas. Our managers have been re-underwriting their portfolios for an extended inflationary period and taking advantage of investing into yields and valuations we haven’t seen for quite some time. Lastly, at the portfolio level, we are evaluating new opportunities in credit and supply chain-related investments and activating strategic cash positions to lock in higher yields where possible.
Glossary of Indices
U.S. Large Capitalization = S&P 500 Index
Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.
U.S. Small Capitalization = Russell 2000 Index
Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.
U.S. Growth Equities = Russell 3000 Growth Index
Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.
U.S. Value Equities = Russell 3000 Value Index
Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.
International Equities (Developed Countries) = MSCI EAFE Index
A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
Emerging Market Equities = MSCI Emerging Markets Index
A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
U.S. FIXED INCOME, TAXABLE
U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index
Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).
TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index
Measures the performance of TIPS of various maturities issued by U.S. Treasury.
INTERNATIONAL FIXED INCOME
International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.
Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.
Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign
Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.
U.S. FIXED INCOME, TAX-EXEMPT
Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index
A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.
Municipals, Broad Market = Merrill Lynch Municipal Master Index
Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.
Absolute Return Funds = HFRX Absolute Return Index
Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.
Market Directional Funds = HFRX Market Directional Index
Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.
Equity Volatility = CBOE VIX Index
Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.
Implied Inflation = 10-Yr TIPS Implied Inflation
Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.
Gold Spot $/oz.
An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.
Oil = Brent Crude Oil Spot Price $/bbl
Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.
U.S. Dollar = Trade-Weighted U.S. Dollar Index
Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data.