Stocks Under Pressure
Stocks saw pressure in the third quarter of the year as market sentiment was negatively impacted by tighter financial conditions brought on by more aggressive rate hike plans. During the quarter, the S&P 500 decreased by -4.9%. There was some variation in performance, with small-cap companies outperforming the market by 2.6% and growth stocks outperforming value stocks by 3.8% respectively. Nevertheless, this year’s performance of various asset classes has shown a notable divergence, with Value companies outperforming Growth stocks by 18.5% as of the end of Q3.
With more possibilities to “buy low, sell high,” this difference in relative performance has improved opportunities for rebalancing across asset classes and may ultimately improve performance over the long term.
Bond Yields Rise, Yield Curve Inverts
Due to tighter monetary policy throughout the third quarter, bond rates increased, which put pressure on bond prices. Shorter-dated bond maturities have a higher yield than longer-dated maturities, reflecting the inversion of the yield curve as measured by yields on Treasury securities. The 10-year U.S. Treasury yield increased, rising from 3.0% to 3.8% after the third quarter. The highly watched two-year / 10-year yield disparity inverted at the same time that the two-year Treasury yield increased by almost 1.3% and ended the quarter at 4.2%.
We think that interest rates have reset to a higher trading band as a result of the Fed’s more aggressive monetary policy approach. With that stated, market pricing has now taken into account the Fed’s new rates forecast, and we are seeing some promising yield prospects. For instance, a portfolio of investment-grade corporate bonds with a medium-term is currently yielding north of 5.5%, which is much higher than the yield on the same portfolio lately.
The dominant theme throughout the third quarter was a focus on more aggressive monetary policies, both domestically with the Fed and also across all major global central banks. Fed officials increasingly focused on the “raise rates higher and hold” messaging as the quarter progressed, and as it became apparent that near-term inflation is likely to stay higher than previously anticipated. This messaging culminated in the Fed raising the fed funds rate by 0.75% at its September Federal Open Market Committee (FOMC) meeting and raising its forecasts for future fed funds rate increases, inferring another 0.75% hike was likely in November followed by a 0.50% hike in December.
Fed Chair Powell has struck a hawkish tone, noting that combating inflation may require a sustained period of below-trend economic growth, again evidenced in the “dot plot” economic forecasts. The still very strong labor market also played into the tighter policy narrative, with Fed Chair Powell noting the labor market has thus far shown only modest evidence of cooling off.
Geopolitics, Seasonality, and Earnings
Geopolitical tensions remained elevated as Russia continued to weaponize energy flows, annexed four Ukrainian regions, and ratcheted up its nuclear warnings. At the same time, the rhetoric between the U.S. and China over Taiwan continued to escalate. Negative seasonality was also highlighted, with September historically a weaker month for the stock market, and company-sponsored buyback activity tends to be reduced ahead of quarter end and the start of Q3 earnings season. Speaking of earnings, Q2 earnings season results and guidance were broadly better than feared. While relatively stable demand was a broad theme across industries and sectors, there was some focus on elevated recession mentions as well as caution around margin pressures, while some high-profile companies announced plans to scale back hiring and, in some instances, announced layoffs.
Inflation Pressures Abating
The peak inflation narrative gained some traction during the quarter, particularly on the back of 99 days of declines for gasoline prices in the U.S. Inflation components of several regional manufacturing surveys softened further in September. Notably, lumber prices were off more than 70% from their peak and back to pre-COVID levels. As a result, forward-looking measures of inflation expectations declined further. With that being said, we continue to anticipate inflation will remain elevated and above the Fed’s long-term target of 2% over the near term, and that inflation will remain somewhat sticky but slowly decelerate towards the 2% level over time. With this backdrop, we have increased exposures to alternative income-generating asset classes we believe will do well in an elevated inflation and rising interest rate environment.
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