October 2022 Market Commentary
November 4, 2022
Though its precise origins remain unclear, modern-day Halloween is widely believed to trace it roots back 2,000 years to the ancient Celtic festival of Samhain. Held on the night of October 31, it was believed that ghosts of the dead returned to walk among the living, who attempted to appease the spirits by offering food. The festival also involved dressing in costumes of animal skins. Through the years Halloween has evolved to incorporate other traditions, but the central element of costumes and food remains. Today’s Halloween is embodied by costumed children standing on the porch shouting “Trick or Treat!”
Like many of today’s elaborate decorations that adorn front lawns, 2022 has been rather frightful for investors. Surging inflation, resulting initially from strong demand and snarled supply chains, has precipitated an increasingly aggressive Fed response, in turn rendering the historical correlation between stocks and bonds moot, leaving investors with few places to hide. However, after a bruising September in which the S&P 500 lost 9.3%, October proved to be a treat for investors with the S&P 500 rebounding 8.0%. For the Dow Jones Industrial Average, October its best month since 1976, as the venerable index gained 14%.
Despite significant volatility, markets lacked any clear direction through the first half of the month. The downfall of UK PM Liz Truss’s government and a Wall Street Journal article suggesting the Fed might be preparing to slow the pace of rate hikes beginning in December drove markets higher in the second half of the month. Additionally, a bevy of data pointing to further economic slowing likely benefitted the markets by further raising hopes that the Fed might consider moderating future rate hikes. For the month, large caps (S&P 500) returned 8.0%, their best month since July and second best since November 2020. Small caps (Russell 2000), which tend to be more economically sensitive than large caps, did even better, returning 10.9%. International returns were mixed with developed markets (MSCI EAFE) gaining 5.3%, while emerging markets (MSCI EM) fell 3.2%. Chinese stocks were the main detractor, weighed down by concerns that President Xi’s confirmation to an unprecedented third term could result in China continuing its Zero-Covid policies, despite the economic impact, and possibly intensifying its crackdown on various sectors including the tech industry.
US economic data released during the month pointed to a further slowing in economic activity. The housing sector continued to stagnate as mortgage rates breached 7.0% for the first time since 2002. For a $1M dollar home financed with 20% down and a fixed 30-year mortgage, the rise in rates from 3.1% at the start of the year, to 7.1% at the end of the month, adds an additional $1,960 per month, to a homebuyer’s mortgage payment. No wonder that new and existing home sales have fallen 18% and 24%, respectively, from a year ago.
On a headline basis, 3Q22 GDP growth of 2.6% was a nice reversal from the negative growth experienced in 1Q22 and 2Q22. After the second quarter, we argued that the economy wasn’t in recession given the underlying strength of the consumer and labor markets. And while we are not yet ready to say the economy was in recession at end of 3Q, it appears to be approaching stall speed. Despite the relatively encouraging headline growth in 3Q22, underlying details were disappointing. Trade, which is typically a minor contributor to growth, added 2.8% to headline GDP, its largest contribution since 1980. Excluding trade, GDP would have contracted 0.2%. Consumer spending, the engine of economic growth, slowed from 2.0% to 1.4%, while business spending contracted for a second quarter, dragged down by a 26% decline in residential housing. After leading the early stages of the post- pandemic recovery, housing activity has now contacted for six consecutive quarters.
Unlike equity markets, bond markets sold off further in October, pressured by rising interest rates. The Bloomberg Agg, the broadest measure of the US bond market, fell 1.3%, bringing year-to-date losses to 16.8%. For much of the month, yields across the curve marched steadily higher as the Fed remained aggressive in the wake of persistently strong employment and inflation data. Though there have been signs of employment and inflation slowing, progress has been frustratingly slow for the Fed’s purposes. Further, despite a modest deceleration in headline inflation, core inflation, has reaccelerated of late. The persistence in inflation has forced the Fed to raise rates by 0.75% at each of its last three meetings and is expected to do so again in early November. As a result, yields along the Treasury curve between three months and 10 years reached their highest levels in 14-15 year.
Sentiment changed abruptly in the second half of the month following a Wall Street Journal article indicating that a further 0.75% increase in December is up for debate. With markets already pricing in a 0.75% hike, the idea that the Fed might consider a smaller move spurred a significant rally. The rally was further aided by comments from various Fed members indicating their support for slowing the pace of future rate hikes. Markets were further encouraged by a lower-than-anticipated hike from the Bank of Canada, and a European Central Bank statement that some perceived to indicate a slower pace of future rate hikes.
Just prior to month end, the release of core personal consumption expenditures (PCE), the Fed’s preferred measure of inflation, showed that prices reaccelerated to a six-month high, corroborating the earlier release of core CPI inflation data. The reacceleration and news that the Fed is considering tempering future rate hikes are effectivity at odds with one another creating both tension and intrigue ahead of the Fed’s November meeting. With a 0.75% hike all but certain, investors will be focused on Fed Chair Jay Powell’s comments regarding future rate hikes. To date, he has remained steadfast that the Fed will remain aggressive until inflation is clearly returning to the Fed’s longer-term target of 2%. Any change in tone now would seemingly contradict previous statements, including those made in his Jackson Hole speech from August in which he stated that “The historical record cautions strongly against prematurely loosening policy.”
Post-Script– On November 2, the Fed announced an additional 0.75% Fed Funds increase. More importantly, Powell intimated that the Fed may be nearing the point at which 0.75% rate hikes are no longer necessary. That said, Powell noted that “incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected.”
Until this year, the phrase “lower for longer” was used to describe the idea that the Fed would maintain low rates for an extended period in order to support economic growth. Following the Fed’s November meeting and Powell’s ensuing comments, investors might consider refashioning “lower for longer” to mean that soon future Fed rate hikes will be lower (i.e. smaller), but will occur over a longer period than previously expected.
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