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.

LOOKING FORWARD:

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.

Index Descriptions:

S&P 500 Index TR is a market capitalization weighted index which represents the broad market for large company U.S. stocks.  Returns reflect the reinvestment of dividends.

The MSCI EAFE Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developed market stocks excluding those from the U.S. and Canada.  Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.

The MSCI EM Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developing market stocks.  Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.

The Bloomberg Barclays U.S. Agg Bond Index is a market capitalization weighted index which represents the broad market for taxable investment grade U.S. dollar-denominated bonds. Returns reflect the reinvestment of interest.

The US Treasury Bill Auction Avg 1-month is an index comprised of short-term U.S. government-issued investments with yields collected weekly and can be considered a proxy for cash.

Portfolio performance, characteristics, and volatility may differ from the benchmarks shown. Opes portfolios are managed according to their respective strategies which may differ significantly in terms of security holdings, industry weightings, and asset allocation from those of the benchmarks. Benchmarks are unmanaged and provided to represent the investment environment in existence during the time periods shown. An index is not available for direct investment, and does not reflect advisory fees, any of the costs associated with buying and selling individual securities, or any other fees, expenses, or charges. Past performance may not be indicative of future results.

The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. All opinions expressed herein constitute the judgment of the author(s) as of the date of the report and are subject to change without notice. The material has been gathered from sources believed to be reliable, however Opes cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. This information may contain certain statements that may be deemed forward looking. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those discussed.  Opes does not provide tax or legal advice, and nothing contained in these materials should be taken as such. As always please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Opes and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Opes unless a client service agreement is in place.