MARKET RETURNS: Global markets continued to sell off in the third quarter as investors incorporated ongoing tightening of financial conditions into asset prices. U.S. dollar appreciation of over 15% year-to-date was reflected in regional equity returns, as U.S. and foreign stocks both fell by mid-single-digits in local currencies while overseas shares declined more significantly in dollar terms. Emerging markets underperformed meaningfully as Chinese stocks dropped on concerns around the country’s property market and zero-Covid policy. Growth proved more resilient than value across the developed world during the quarter, though value has still outperformed meaningfully so far this year with energy the only sector in positive territory. High quality bond prices continued to fall as the yield on the benchmark 10-year Treasury Note reached levels not seen for a decade, rising rapidly following Chairman Powell’s hawkish comments in Jackson Hole. Currency was also a major factor in international bond underperformance, since less aggressive interest rate policy from foreign central banks has translated to more muted bond price impacts in local terms. Cash and equivalents were a relative bright spot as higher short-term interest rates translated into a positive rate of return.
|Asset Class||Index||3rd Quarter
|Year to Date|
|US Large Cap Equities||S&P 500 Index TR||-4.88%||-23.87%|
|Int’l Developed Equities||MSCI EAFE Index NR USD||-9.36%||-27.09%|
|Emerging Market Equities||MSCI EM Index NR USD||-11.57%||-27.16%|
|Fixed Income||Bloomberg Barclays U.S. Agg Bond Index||-4.75%||-14.61%|
|Cash||US Treasury Bill Auction Avg 1-month||0.56%||0.76%|
|See “Index Descriptions” for more information at the end of this document|
Inflation and Monetary Policy: Market participants are largely focused on the seismic shift in interest rate policy caused by arguably the first meaningful inflationary pressures in a generation, which we discuss in more detail in our latest quarterly video. The implications for the real economy and financial markets are wide-ranging. Borrowing costs have increased dramatically for individuals, businesses, and governments, prompting a re-evaluation of investment and consumption decisions. Prices for bonds issued when rates were much lower have fallen to compensate investors who could receive higher rates on newly issued securities. Stock valuations have also come under pressure since future profits are less valuable today if prices for goods and services are expected to increase more rapidly. This is particularly the case for growth stocks with cash flows skewed toward the distant future rather than the present.
A spirited debate regarding the appropriate path for monetary policy is raging among economists, with strong opinions from accomplished and influential figures on both sides. The conclusion is unclear because of the delay between policy action and the release of economic data showing its effects. This can take between three to six months in many cases as loans reset, borrowers react, and data series are compiled and reported. The rapid pace of U.S. rate hikes shown in the accompanying chart amplifies the effect of these lags. The result is that data-dependent central banks are left in a position similar to driving a car by looking in the rear-view mirror. We are sympathetic to the Fed’s approach of erring on the side of hawkishness since we view the risk of failing to contain inflation as more severe than overly constraining economic growth. Yet the nature of the situation means nobody will know the optimal policy path with certainty until we see the data.
A fundamental tenet of economic theory is that prices are set at the intersection of supply and demand. Central bank policy can regulate demand through the transmission channels described above, but its effect on supply is indirect at best. Supply drivers are important yet idiosyncratic, as illustrated by several examples. Energy prices are influenced by geopolitics and environmental concerns, both of which play a role in the situation in Europe as winter approaches. Home prices are affected by interest rates and building costs: homeowners that refinanced mortgages during the pandemic are reluctant to move (since mortgage interest rates would be much higher) thereby reducing the supply of housing for sale, while higher labor and material costs make it more expensive to build new homes. Finally, business inventories are impacted by supply chains and customer preferences: many items that were difficult to find when they were in high demand have become available just as consumers shift their spending from goods to services.
Conclusion: Focusing on the future and maintaining discipline in the face of uncertainty are two key components of successful long-term investing. We believe there are many reasons for optimism going forward despite the highly unusual simultaneous double-digit declines in both stocks and bonds so far this year. Historically, markets tend to settle into equilibrium after adjusting to shocks like rapid tightening of monetary policy. Interest rate normalization means that bonds are once again producing reasonable levels of current income. Stock valuations, while not particularly useful as a timing tool, are now implying returns in line with historical averages over the intermediate term. Even inflation should eventually result in higher corporate sales and potentially profits as price increases are passed through to customers. It’s worth keeping these dynamics and your long-term plan in mind as asset prices continue to react to incoming data and perceived changes in the near-term outlook.