This article is brought to you in collaboration with our colleagues at Laird Norton Wealth Management from their post, Economic Flash: Inflation Isn’t Everything, It’s the Only Thing.
U.S. Economy: Good News is Bad News
In a vacuum, recent data paints a positive economic picture. Personal income (+0.3%), spending (+0.4%) and labor force participation all rose, up 0.3%, 0.4% and 62.4% respectively, while consumer sentiment at 58.6 is slightly up from all-time lows. However, with core inflation running hot at 6.2% Core PCE, hawkish Fed policy to slow the economy is likely to continue.
U.S. Stocks: Bad Start to Autumn
Septembers have frequently challenged equity markets and did so in 2022 as U.S. large-cap stocks fell more than 9%, bringing the S&P 500 back to its level at the start of December 2020 with losses across sectors: Only defensive health care stocks, down 2.6%, were down less than 7.5%. Analysts have cut their estimates for quarterly earnings growth by the most since early 2020.
Foreign Stocks: Currency Woes
The tremendous 2022 rally in the U.S. dollar has been a formidable currency headwind for international equities and emerging economies. In September, currency translation detracted about 3% from foreign stock returns. Notably, the pound hit near parity with the dollar, as new British PM Liz Truss proposed cutting taxes and loosening fiscal policy.
Fixed Income: Volatility Spikes
The bond market rout deepened, as 10-year U.S. Treasury yields rose nearly 80 basis points to 4.0% before returning to 3.7% in early Oct. While many investors were looking for equity market volatility to peak before calling a market bottom, bond market volatility spiked to levels last seen in 2008 during the global financial crisis, a potential sign of market capitulation.
Real Assets: Cooling Off
Real assets have been a reasonably effective diversifier amid broadly negative financial markets in 2022, but September broke the trend. Concern about a weakening global economy led all major commodity sectors into negative territory. Meanwhile, REITs continued their slide on rising interest rates, which have made bonds relatively more attractive from an income perspective.
Alternatives: Hedge Funds Plug On
Absolute return hedging strategies continued to benefit from market volatility, while managed futures strategies benefited from the upward trend in interest rates. Although equity-biased strategies struggled in September as hedges were not totally offsetting the magnitude of the equity selloff, they also acted as shock absorbers relative to traditional equities and fixed income.
Equities Total Returns
Fixed Income Total Returns
“May you live in interesting times” is an expression used ironically with which you might curse an enemy. The notion is that it is better to live in periods that are uneventful versus those that are marked by change, such as what we have lived through since March 2020, and from a market perspective what we have experienced so far this year. Without doubt, we are living through a macroeconomic and market environment with few comparisons through history.
One key driver of the dismal market performance in 2022 that has not received much attention is the shrinkage in the global money supply. Since this spring, the Fed has been essentially closing not one but two spigots of monetary support: It has been raising interest rates since March and selling bonds on its balance sheet since May. The resulting drop in liquidity is indeed a shock after the massive influx of money to offset the economic impact of COVID. The Fed’s ability to manage both these maneuvers delicately without overcooling the economy and disrupting financial markets remains the greatest risk we see ahead of us.
Much tighter monetary policy coupled with relatively high inflation is negatively impacting both stocks and bonds simultaneously. As a result, the staple 60/40 stock/bond portfolio is down more than 21% this year through September. Were that to be the full-year return for 2022, it would make this the 60/40’s worst calendar year in at least five decades. Also, because the 2022 bear market is occurring 14 years after the global financial crisis in 2008, it has dragged down long-term performance results (the past three, five, and 10 years) for public market investments, which nine months ago looked much more respectable.
What Has Worked
While the reputation of the 60/40 portfolio has taken a hit as an all-weather investment strategy, diversification has worked, albeit less than investors would have preferred, and it has come from places other than traditional fixed income. Lower market sensitivity investments within public markets such as real assets, like infrastructure and commodities, and short-term bonds have provided some ballast whereas private market exposures and hedge fund strategies have also added value. Extensive diversification is continuing to add value, and we believe that investors would be worse off without it as global equities have fallen nearly 26% year-to-date.
In challenging years like 2022, it is too easy to lose sight that there are also potential positive catalysts that at some point can and will change the sentiment, the direction of markets and the economy, including the Fed slowing or stopping further rate hikes; the end of China’s Zero-COVID policy, which could happen as soon as mid-October during China’s 20th Communist Party Congress; a potential end to the war in Ukraine, and other developments that are not yet on our radar screen today. The current environment is not without opportunities as well. The spike in short-term rates has distorted the yield curve so that short-term bond yields now mirror those of long-term bonds. It may be possible to improve portfolio risk-adjusted returns by locking in those higher relative yields at the expense of cash and other short-term investments.
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.