Part 1: Looking back at Q3 2022
Part 2: What actions did we take in McKinley Carter portfolios in Q3?
Part 3: A look ahead - our outlook for the rest of 2022
Looking back at Q3 2022
Sailing through rough seas is a frightening experience that feels like it will never end. Fortunately, rough seas eventually give way to calmer waters and a more comfortable sailing experience. Coming off strong stock performance for several years, the stock market has endured its own stormy seas this year with a significant pullback in 2022 as global economic concerns brought about by multi-decade highs in inflation, rising interest rates, and the war in Ukraine, have crushed investor optimism. We’ve experienced an unusual phenomenon this year – the simultaneous decline of stock and bond markets. Throughout the third quarter, investors’ concerns focused on global instability, rising prices and the possibility that central bank efforts to tame inflation would cause economic growth to falter. The result has been tremendous volatility in stock and bond markets.
We titled our last quarterly report, “Bloodied but Unbowed,” reflecting a stock market that we believed over-corrected in a short period of time due to fear of rising interest rates and inflation and the impact of the war in Ukraine. Subsequent to our report, the stock market rose nearly 14% from June 30th to August 16th where the rally ended, and prices began to fall again due to concerns over new inflation data.
Unfortunately, while the Federal Reserve recently met expectations by increasing the Federal Funds rate by 0.75%, they did indicate their intention to press short-term interest rates markedly higher than their previous targets, and this declaration upset both the stock and bond markets. Complicating matters, Fed chair, Jerome Powell, stated that economic “pain” may be the price for bringing down inflation.
The third quarter started with a solid rebound in stocks and bonds that was driven by resilient corporate earnings, signs of a possible peak in inflation, and hints from the Federal Reserve that the end of the rate hiking cycle may come sooner than markets initially expected. Starting with earnings, corporate results for the second quarter were much better than feared. Despite high inflation and lingering supply chain issues, the majority of Q2 earnings reports beat estimates, and that solid performance by corporate America showed investors that, despite numerous macroeconomic challenges, U.S. earnings were holding up much better than expected. On inflation, several survey-based economic reports showed price declines in June and offered hope that inflation pressures were peaking. Finally, in late July the Federal Reserve raised interest rates by another 75 basis points, but at the press conference Fed Chair Powell stated that, at some point in the future, it would be necessary for the Fed to slow the pace of interest rate increases. Investors interpreted that comment as a signal that the end of the rate hike cycle may be closer than previously thought. Hope for a less-aggressive Fed paired with resilient earnings and a possible peak in inflation fueled a 9.2% gain in the S&P 500 in July, its best monthly return since November 2020.
Stocks continued higher through the first half of August, driven by more proof of a peak in inflation and the growing hope that the Federal Reserve would soon “pivot” to a less-aggressive policy stance. Specifically, the July CPI report (released in August) showed clear moderation in price pressures, further entrenching the idea that inflation had peaked. Investors welcomed this news and confirmation of a peak in inflation, combined with the aforementioned hope of a “Fed pivot,” pushed the S&P 500 to nearly four-month highs by mid-August. But ultimately, the move higher in July and early August was nothing more than a “Bear Market” rally. In late August, while making remarks at the Jackson Hole Economic Symposium, Fed Chair Powell dismissed the idea of a looming Fed pivot to a less-aggressive policy, dashing hopes that the end of the rate hike cycle was in sight. The reiteration of aggressive policy and historically large rate hikes combined with the warning of looming economic pain hit stocks late in the month, and the S&P 500 gave back all the early August gains to end the month solidly lower, down 4%.
The selling continued in September, as the August CPI report (released in September) showed a slight increase in prices, implying that while inflation pressures had potentially peaked, inflation was not rapidly declining towards the Fed’s target (meaning rates would likely stay high for the foreseeable future). Then, at the September FOMC meeting, the Federal Reserve again hiked interest rates by 75 basis points and signaled rates will continue to rise to levels higher than previously expected. Geopolitical concerns also pressured stocks in September as Russia escalated the war in Ukraine by holding referendums in occupied Ukrainian territory, and by announcing a 300,000-person “mobilization” from the general Russian population. Finally, during the last few days of the month, global currency and bond markets saw a dramatic increase in volatility, as the government of the United Kingdom announced a spending package designed to stimulate the economy. But that would also likely add to inflation pressures and the announcement resulted in a spike in global bond yields while the pound collapsed to an all-time low vs. the dollar, adding to general macroeconomic volatility. The combination of sticky inflation, expectations of numerous future Fed rate hikes, rising geopolitical tensions, and currency and bond market volatility weighed heavily on stocks and bonds into the end of September, as both markets finished the quarter near the lows for the year.
In sum, the third quarter started with optimism surrounding a resilient corporate earnings outlook, a potential peak in inflation, and a closer-than-expected end to the current Fed rate hiking cycle. But throughout August and September, that optimism was eroded by sticky inflation data and a more hawkish-than-expected Federal Reserve.
Third Quarter Performance Review
- All four major stock indices posted negative returns for the third consecutive quarter, although unlike the first two quarters of 2022, the tech-heavy Nasdaq did not badly lag other indices and the quarterly declines were fairly uniform across the most widely followed U.S. equity indexes.
- By market capitalization, small-cap stocks outperformed large-cap stocks for the first time this year. Small cap outperformance came mostly from gains early in the third quarter as markets broadly rallied on hopes of a quick decline in inflation and a sooner-than-expected Fed pivot.
- From an investment style standpoint, both value and growth registered losses for the second straight quarter. However, unlike the first half of 2022, growth relatively outperformed value in the third quarter. Growth enjoyed a strong rebound early in the quarter, again as markets rallied on the hope of peak inflation and a Fed pivot that would signal a peak in interest rates. However, that growth outperformance shrank late in the quarter as inflation remained high and the Fed signaled there was no imminent end to the rate hiking cycle.
- On a sector level, just one of the 11 S&P 500 sectors finished the third quarter with a positive return. Consumer discretionary posted a positive return thanks to strong consumer spending and still-low unemployment. The energy sector, meanwhile, finished the quarter with a fractional loss as energy stocks benefitted from solid earnings and strength in natural gas prices. More broadly, traditionally defensive sectors relatively outperformed over the past three months, as investors positioned for slower future economic growth.
- Sector laggards in the quarter included communication services, real estate, and materials. Communication services have lagged throughout 2022 as investors shunned expensively valued tech companies. Real estate, meanwhile, declined in the face of spiking mortgage rates and as home price appreciation began to slow. Finally, the materials sector traded lower following earnings warnings from multiple chemical companies and a sharp drop in certain commodities prices in the third quarter, which was driven by a stronger dollar and growing worries about the global economy.
- Internationally, foreign markets badly underperformed U.S. markets during the third quarter, as surging electricity prices in Europe and the U.K., interest rate hikes by the European Central Bank and Bank of England, and lasting geopolitical risks weighed heavily on foreign developed markets. Emerging markets, meanwhile, underperformed both foreign developed markets and U.S. markets as a surging U.S. dollar offset hopes for a continued economic reopening in China.
- Commodities dropped sharply in the third quarter as a combination of a multi-decade high in the U.S. dollar, growing fears of a global recession, and sharply rising real interest rates weighed on industrial commodities as well as traditional safe havens like precious metals. Oil prices fell in the quarter as concerns about future demand offset geopolitically based worries about supply. Gold, meanwhile, logged solidly negative returns for the second straight quarter thanks to rapidly rising real yields, the surging dollar, and fading market-based inflation expectations.
- Switching to fixed-income markets, most bond indices posted solidly negative returns for the third straight quarter. Looking deeper into the bond markets, shorter-term Treasury Bills outperformed longer-duration Treasury Notes and Bonds as the threat of greater than previously expected Fed rate hikes and still-high inflation weighed on fixed income products with longer durations.
- For the second straight quarter, short-term Treasury Bills finished the quarter with a slightly positive return. Corporate bonds relatively outperformed longer-duration government bonds in the third quarter thanks mostly to still-solid U.S. economic data. Higher yielding, lower quality corporate debt declined less than investment grade corporate bonds as resilient corporate earnings kept default risks generally low.
|U.S. Equity Indexes
|DJ Industrial Average
|S&P MidCap 400
|International Equity Indexes
|MSCI EAFE TR USD (Foreign Developed)
|MSCI EM TR USD (Emerging Markets)
|MSCI ACWI Ex USA TR USD (Foreign Dev & EM)
|S&P GSCI (Broad-Based Commodities)
|WTI Crude Oil
|U.S. Bond Indexes
|BBgBarc US Agg Bond
|BBgBarc US T-Bill 1-3 Mon
|ICE US T-Bond 7-10 Year
|BBgBarc US MBS (Mortgage-backed)
|BBgBarc US Corporate Invest Grade
|BBgBarc US Corporate High Yield
What actions did we take in McKinley Carter portfolios in Q3?
In ActiveTrack (AT) and Earnings Focus (EF) accounts, we sold a partial position in the Vanguard Developed Markets Index Fund (VEA) and used the proceeds to fund a position in the iShares MSCI EAFE Growth ETF (EFG).
In AT accounts, we sold all the iShares Russell Mid-Cap Value ETF (IWS) position and used the proceeds to fund an equal position in the iShares Morningstar Mid-Cap Growth ETF (IMCG).
In light of slowing economic data both in the U.S. and abroad, the Strategy Committee felt that a more neutral position was warranted with respect to growth stocks vs. value stocks. Previously, our portfolios had a slight bias towards value stocks as valuations had been more favorable there for some time.
With economic growth slowing and signs of peaking inflation, the committee added more growth stock exposure to both our domestic and international holdings in order to have a balanced allocation.
In Dividend Focus (DF) accounts, as a result of a review of our rankings for the iShares Emerging Markets Dividend ETF (DVYE), we replaced it with the iShares Core MSCI Emerging Markets ETF (IEMG – currently used in MarketTrack models) in all DF models. As DVYE was a watch list violator due its underperformance vs. the Diversified Emerging Markets category, replacing it with IEMG removed a watch list violator and maintains the dividend-oriented approach of the DF model. IEMG carries a current yield of 4.03%.
Approved swapping four stocks in EF models due to better scoring within our system:
- Selling CarMax Inc. for Tesla Inc.
- Selling Abbott Laboratories for Centene Corp
- Selling Stanley Black and Decker Inc. for W.W. Grainger Inc.
- Selling S&P Global Inc. for Arthur J. Gallagher & Co.
A look ahead - our outlook for the rest of 2022
As we start the fourth quarter, markets remain in search of concrete positive catalysts that signal declining inflation pressures and a less-aggressive Federal Reserve. Currently, the markets are focused on three things:
- When will inflation officially peak?
- When will rates stop going up and how high will they go?
- How severe is the economic slowdown and what is the impact on corporate earnings?
1. As to when inflation is going to peak, the August Consumer Price Index report was disappointing and reflected still high food, housing, and medical costs. Also, elevated wage pressures may continue for some time due to a workforce participation level that is still lower than pre-pandemic levels.
However, many commodity prices are in sharp decline such as oil and gasoline which peaked in early June at levels well above current prices.
Additionally, other important commodities such as gold, silver, copper, uranium, lumber, wheat, soybeans, cotton, and milk peaked between March and May of this year. The price for another important commodity, steel, actually peaked in October of last year.
Supply chain bottlenecks, which have been cited as a source of inflationary pressures, have also lessened significantly as of late as the Global Supply Chain Pressure Index has declined for five straight months.
Global Supply Chain Pressure Index
Furthermore, home prices may well be peaking as building permits for new homes, a good indicator of housing activity, have recently fallen sharply.
Evidence that inflation expectations over the next few years are declining can be found in the chart of the 5-yr. Breakeven Inflation Rate which gauges how markets are pricing in inflation risks over the next 5 years. The current expectation for 5-yr. inflation has fallen to 2.26% from 3.59% in March and is back to levels last seen in February of 2021.
2. Reflecting on interest rates and when they might stop going up, the terminal rate, where Fed hikes are projected to end, is now estimated to be at 4.6% and happen in the spring. The Fed has indicated that they would like the Fed Funds rate to be at 4.4% by year-end 2022 vs. 3.1% today, a level much higher than they forecast just a few months age. The stock and bond markets are under stress as a result of the Fed constantly “moving the goal posts” of rate increases.
3. Regarding the outlook for the economy and corporate earnings, there is no question that growth is decelerating globally, and the U.S., while in a better position than most other countries, is certainly not immune. With the Fed strongly indicating that fighting inflation is far more important than the fallout of a potential recession, risks to the U.S. economy and earnings have risen significantly. Recently, analysts have been lowering their earnings estimates for the S&P 500, and these negative revisions have led to downward pressure on the markets. Hurt by a 20-yr. high in the U.S. dollar (which hurts exports), estimates for this year and next are now indicating little growth, outside of some good earnings from the energy sector.
While we don’t believe that the U.S. economy is currently in recession with very low unemployment, historically low unemployment claims being filed, and robust wage growth (6.1%), we acknowledge that the odds of a recession happening over the next year have increased markedly as a result of the impact of the dramatic rise in interest rates.
Our position on the equity markets is one of caution over the near term as investors factor in the impact of rising bond yields on the economy and stock prices. As more evidence of declining inflation is reflected in future Consumer Price Index reports, we believe markets will stabilize. The stock market is a discounting mechanism of future earnings and when the Federal Reserve is no longer acting as the market’s adversary, stocks will likely find their footing.
However, should the Fed maintain its aggressive policy towards interest rates well beyond the point that compelling evidence of a decline in overall inflation is seen, equity markets will likely experience a more prolonged downturn.
In fixed income, we believe that Treasury bonds that pay interest rates above 4% serve as strong competition to stock prices as investors lock in government guaranteed returns.
Geopolitical tensions remain very elevated as Russia has recently escalated the war in Ukraine and the risk of a broader conflict simply can’t be ruled out. But most Western countries remain united in their opposition to the Russian invasion of Ukraine and that will continue to be a powerful deterrent to Russian President Putin. Additionally, even some of Russia’s most important allies, including China and India, have voiced concerns about the escalation of the war over the past month which has further isolated Russia from the global community. Any reduction in geopolitical tensions would provide a surprise boost for global risk assets, including U.S. stocks and bonds.
In sum, while markets continue to be challenged by rising rates and economic uncertainty, history shows that investors who take advantage of significant pullbacks in stocks during troubled times for the economy and periods of excessive pessimism as we see now, are generally rewarded over longer periods of time. Patience, while difficult in the moment, has always been the best path to long-term wealth building.