Summary, Third Quarter of 2022:
Equity markets attempted a rebound in the third quarter (Q3) but eventually declined when inflation caused the U.S. Federal Reserve (the Fed) to aggressively tighten interest rates. The war in Ukraine has lasted longer than expected, adding to inflationary pressures, and natural gas pipeline sabotage has put Europe in a vulnerable position heading into winter. The European Central Bank (ECB) has been busy fighting inflation as well but appears to be reversing course given Europe’s recent economic weakness. China is dealing with a recession as their “Zero Covid” policy has created fits and starts for economic growth while supply chains have shown some signs of progress. Meanwhile the Fed’s rate hikes have been felt in the U.S. housing market where affordability has deteriorated significantly while other parts of the economy continue to see inflationary pressures.
Inflation is a problem if it gets out of hand, but so is overly restrictive monetary policy. The Fed has a dual mandate of 2% inflation and 4% unemployment. According to the PCE, the Fed’s preferred inflation measure, inflation is currently 6.25%, while the unemployment rate is 3.70%. The obvious implication is that the Fed has room to increase rates because inflation is too high while the jobs market is very healthy—in fact, many employers can’t hire enough workers. In order to achieve the elusive “soft landing,” the Fed must raise rates enough to cool the economy but not so much that it drives it into a recession. Given the healthy unemployment numbers, the Fed has room to maneuver.
The work the Fed has already done has impacted parts of the economy. Housing affordability has deteriorated significantly. The 30-year mortgage rate has crossed over 7%, a level not seen in almost twenty years. Some larger companies are announcing layoffs or hiring freezes, but there are also pockets of the economy—espeically in the “marginal” worker areas—where employers are having a hard time finding workers. Wages have been increasing, and as that continues, sought-after marginal workers should be lured back to work. Unemployment will increase as the Fed relies on the consumer, the largest segment of our economy, to get us through this rate hiking period. This is the “pain” that Fed Chairman Jerome Powell has referred to in recent speeches. While it can be difficult to stomach, this is a normal aspect of employment reshuffling, which took an unusual form during Covid.
Investors showed their true desire in Q3 when markets attempted to rally in expectation of a slowing inflation rate. That rally was thwarted in August when Fed officials announced a 0.75% rate hike accompanied by hawkish rhetoric on inflation. For a sustained rally to occur, inflation needs to decrease enough to appease the Fed and thus end their current rate-hiking regime. The futures market expects another 0.75% rate hike in November, a 0.50% rate hike in December, and a 0.25% rate hike next February. Until then, we expect more pressure on stocks and volatility. The silver lining for equities is that the recent selloff has created strong buying opportunities for competitively advantaged companies. For the long-term invetor, opportunites like this are rare.
Interest rate hikes are beginning to help one asset class that has been a laggard for a long time now—the bond market. Bonds are finally beginning to offer attractive returns, albeit with inherent risk. As with equity investing, we focus our bond investing on high-quality issuers and shorter durations if possible. Commodities appear to be peaking, which tends to occur during the late stages of the business cycle. That is partly due to demand and partly due to supply chain shortages. As supply chains heal, inflationary pressures will naturally abate, which the Fed hopes will happen sooner than later. This would go a long way in the Fed’s hopes to achieve a “soft landing” for the economy.
Until next quarter,
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