U.S. Economy: Less Pain at The Pump
Cracks are showing in areas that mark a weakening economy. Notably, there is weakness in personal spending, durable goods orders, and most real estate data. However, consumer confidence rose for the first time in four months as the average price of gasoline nationally tumbled to $3.84 from over $5.00 and inflation showed signs of moderating.
U.S. Stocks: Tech Belt-Tightening
August saw the return of several equity market trends in place prior to July. Energy and utilities, up 2.8% and 0.5% respectively, were the only positive sectors, whereas growth-oriented sectors such as technology, down 6.1%, were among the laggards. Tech heavyweights Apple, Alphabet and Amazon each plan to curtail hiring due to inflation and economic growth concerns.
Foreign Stocks: EM Strength
Returns in emerging markets rebounded in August. India and Brazil, up 4.4% and 7.0% respectively, led amid COVID recovery in India and higher natural gas prices combined with easing political concerns in Brazil. That said, China’s dogged pursuit of a Zero-COVID policy continues to pose a risk to global growth and supply chains, most recently restricting the movement of 65 million people in 33 cities.
Fixed Income: Fed’s Hard Stance
The Fed’s stated goal is to bring inflation back down near 2%, suggesting ongoing interest rate hikes despite “some pain” for the economy. The yield on 10-year U.S. Treasuries rose to 3.2% in August, even as inflation expectations for the next three and five years fell to 3.2% and 2.3%, respectively, while the most economically sensitive equity sectors are down dramatically, which is a leading indicator.
Real Assets: Commodities Disparate
Commodities led real assets that are more inflation-sensitive, but not all contracts benefited. Both industrial, down 2.7%, and precious metals, down 4.9%, suffered on weakening global demand and the rising U.S. dollar respectively. Meanwhile, agricultural and soft commodities, up 3.6% and 8.4% respectively, surged with extremely hot weather and supply chain disruptions a tailwind for each.
Alternatives: Hedge Funds Lead the Way
With limited exception, hedge fund indices showed uniform, incremental gains. Such alternative strategies performed relatively well as inflation and interest rate concerns contributed to elevated volatility while M&A activity picked up moderately. In this environment, CTA/Managed futures strategies, up 3.3%, performed well as did the Event Driven category, which was up 2.1%.
Equities Total Returns
Fixed Income Total Returns
In August, financial markets gave back a fair share of July gains as sentiment turned pessimistic on inflation and interest rates. While it was certainly nice to see inflation cooling off a bit as the year-over-year CPI fell from 9.1% to 8.5%, and the Fed’s preferred metric, the Core PCE Index, fell from 6.8% to 6.3%, those figures remain well above the Fed’s objective of 2.0%. In July, investors were optimistic that a softening in consumer spending and real estate data would deter the Fed from raising rates too far too fast at the expense of the economy.
However, positive sentiment faded in August as interest rates resumed their rise, and Chair Jerome Powell underscored that the Fed will do whatever it takes to bring down inflation. At the end of last year, we identified Fed policy error as one of the greatest risks to financial markets and the economy, and that remains the case. With Powell’s comments in hand, and the intent of the Fed’s actions clear, it now seems more correct to say simply Fed policy is a major risk.
While you will rarely find us willing to try and pin the tail on the donkey in the economic realm, we are constantly evaluating the range of market and economic possibilities. Top questions on investors’ minds: How high will interest rates go, and how quickly can inflation come down? The U.S. Treasury yield curve provides some insight into both.
On interest rates, the currently inverted yield curve indicates that anticipated hikes in the Fed’s key interest rate have already driven short-term rates higher: The 12-month T-bill currently yields more than 4%, much higher than the Fed funds rate of just under 2.5%. Meanwhile, the fact that yields on intermediate and longer-term bonds are lower than on short-term debt suggests a market consensus that weaker growth and falling inflation are likely to pull interest rates back down over the following handful of years. Of course, markets, like tea leaves, can and often do get things wrong.
Toward Inflation 2.0%
Inflation has turned out to be less transitory than initially expected by many economists. That said, some of the less structural elements of the rise in inflation have moderated and suggest inflation will come down, albeit slowly. The falling price of gasoline, down 9.5% since June, due to the strong U.S. dollar and weakening global demand was the predominant factor in cooling inflation for July and August. Still, even if inflation does begin to cool meaningfully, it appears that path could remain above the Fed’s target over the next few years, which is a meaningful portfolio consideration and warrants continued emphasis on inflation-benefiting real assets.
Ultimately, the data we get in the coming months on inflation, economic fundamentals and corporate earnings, which have been trending down, will be critically important in clarifying the economic and investment landscape. Until then, uncertainty regarding the speed and magnitude of future rate hikes versus material signs of slowing growth and inflationary pressures will likely make volatility a constant. While this type of environment can cause anxiety over portfolio positioning, if we have done our job of building portfolios with a long-term foundation correctly, this is a time when we can add value as dislocations present new investment opportunities. Remaining disciplined when markets test your resolve should be kept top of mind as we head into September, historically the worst month of the year for the S&P 500.
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.