September 2022 Market Commentary
October 7, 2022
“Don’t fight the Fed.” It’s a common market mantra, but not always heeded. Since March, when the Fed began its current rate tightening cycle, the market has routinely underestimated the Fed’s commitment to bring inflation to heel. No doubt some of this is due to recency bias, the behavioral tendency to base decisions on conclusions drawn from recent events. In other words, letting recent events inform the decision-making process regardless of the validity of the conclusion(s) or the probability of the outcome(s).
Following the Great Financial Crisis of 2008-09, the Fed, with few exceptions, took an accommodative approach to monetary policy. So much so that investors talked openly about the Fed “put,” the notion that the Fed would willingly support markets during periods of heightened volatility. As a result, investors lost sight of two things: 1) the Fed’s ultimate commitment is to price stability, not supporting the markets, and 2) the Fed’s efforts to fight inflation in the early 1980s were not a mere historical footnote, but a potential precedent for future Fed actions.
Further compounding investors’ inability, or perhaps unwillingness, to accept the Fed’s current commitment to fighting inflation is the fact that just two-and-a-half years ago the Fed, and Congress, were doing everything possible to support financial markets, and an economy, in free fall. Even as recently as late 2021, both fiscal and monetary policy were still highly accommodative in supporting the post-pandemic recovery. Thus, it has been particularly difficult for investors to fully accept just how much has changed over the course of 2022.
With September’s selloff, however, markets appear to have finally accept the new reality. A reality in which rather than providing support during periods of market stress, the Fed is now okay with being the cause of market stress as it pushes forward with its inflation-fighting efforts. That reality was reinforced by the Fed’s third consecutive 0.75% rate hike in September, as well as the Fed’s updated projections for interest rates, economic growth, and unemployment, and comments by multiple Fed officials that the central bank must remain committed to its current course on monetary policy despite the likelihood of attendant economic “pain.”
In addition to concerns about inflation and the Fed’s response to it, slowing corporate earnings growth is receiving greater attention. For much of the year, markets were relatively sanguine about corporate earnings, despite some talk of inflation-induced margin compression. Of late, however, markets have become increasingly concerned as FedEx, Nike, Intel, Ford, and others have issued gloomy profit warnings. Current estimates for 3Q22 and 4Q22 earnings growth are 3.7% and 4.9%, respectively, down from 10.7% and 9.8% at the end of June. The fear, however, is that earnings may see additional downward revisions, leading to further equity market declines.
The combination of these concerns resulted in large caps (S&P 500) falling 9.3% in September. The decline was the S&P 500’s worst monthly performance this year and consistent with September historically being the worst calendar month for stocks. Small caps (Russell 2000) also fared poorly, falling 9.7%. International markets did no better. Developed markets (MSCI EAFE) fell 9.7%, hurt by further tensions between Russia and western Europe over energy policy, while Emerging Markets (MSCI EM) lost 11.9%. Commodities, which initially benefited after the outbreak of fighting between Russia and Ukraine fell 8.1%, due in part to an 11% decline in oil prices, as concerns about slowing global economic growth weighed on future demand forecasts.
Investors’ largest economic concern remains whether the Fed can affect a “soft landing.” That is, can it raise rates enough to lower inflation without triggering a recession, something the Fed has noted will be “very challenging.” Speaking at his press conference after the Fed’s September meeting, Chair Powell acknowledged that “no one knows with any certainty where the economy will be a year or more from now” or whether the Fed’s actions will cause a recession and if so what the severity of the recession would be.
Economic data released during the month generally pointed to slowing, but not recessionary, conditions. Inflation data proved disappointing, as a further decline in the annual pace of headline CPI was overshadowed by the fastest annual pace of core CPI in five months. The increase quashed growing hopes that the Fed might be able to take a less aggressive stance towards monetary policy. Despite growing recession fears, labor market conditions have remained robust. Though the Fed expects unemployment to rise in the months ahead, employers thus far have been reluctant to reduce headcount. Here again, recency bias may be at work. Following a period in which many businesses struggled to attract and retain employees, employers now appear reluctant to cut jobs.
Concerns about higher inflation, and a corresponding rise in bond yields dealt the Bloomberg US Agg, the broadest measure of the US bond market, its largest monthly decline since 1980, down 4.3%. All sectors experienced losses. Investment-grade corporates fell 5.3%, while high-yield corporates fell 4.0%. Munis fell 3.7%. Longer-dated bonds were particularly impacted by rising rates, with the 30-Year Treasury falling 9.1%.
A relatively quiet start to the month gave way to heightened volatility following the release of CPI data showing core inflation double expectations. With another unexpected inflationary shock, markets prepared for continued Federal Reserve aggressiveness. Yields moved higher accordingly. A week later the Fed raised rates by another 0.75% and delivered a firm message – they will do what it takes to bring inflation back in line with their 2% target. In addition, the Fed’s updated “Dot Plot” showed a median Fed Funds rate of 4.4% to end the year, a full 1% higher than the prior quarter’s forecast. Additionally, multiple Fed members forecasted a terminal rate approaching 5%.
Near the end of the month, the 10-Year Treasury yield briefly touched 4%- a level last seen in October 2008- as a surprise budget plan released by the new UK Prime Minister sent UK yields soaring and pushed US yields higher as well. Days later the Bank of England stepped in promising to by bonds “on whatever scale is necessary” to regain market stability. Markets immediately calmed, leading the 10-Year Treasury to end the month at 3.83%. Despite the late month reprieve, yields still increased 60-75 basis points across the 2-10yr Treasury curve on the month. Municipal bonds saw a similar pattern, with a typical lag, and now offer the highest yields since early 2011.
Looking forward, market volatility will likely remain elevated until inflation is on a sustainable downward trajectory. As the first two days of October revealed, any talk about a potential Fed “pivot” may produce periodic relief rallies (the S&P 500 gained 5.7%). However, those could prove to be fleeting. To quote Fed Chair Jay Powell following the Fed’s September meeting, the Fed has both the “tools” and “resolve” to restore price stability and is “committed” to doing so.
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