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Q3: A Tale of Two Quarters

Donald Calcagni

MBA, MST, CFP®, AIF®, Chief Investment Officer


CIO Perspective

What a difference 90 days can make. On the heels of historic rate hikes in May and June, global stock and bond markets rallied, with the Russell 3000 climbing nearly 15% and the Barclays US Aggregate returning 1.86% through August 15.1 July’s inflation numbers, which showed that headline inflation had flatlined to 0%, suggested the Fed’s newfound hawkishness was working to reign in prices. For a moment, it seemed the Fed would pull off a “soft landing” and that 2022’s bear market would end with a whimper rather than a roar.

All that changed by late-August, as increasingly hawkish comments by Fed chairman Jerome Powell and several other board members called into question the market’s thesis that the Fed would slow or reduce planned future rate hikes. Much to the surprise of markets and economists, August’s CPI report showed an acceleration in core inflation (reversing July’s declines), prompting more tough talk from the Fed and cementing another 0.75% at their September meeting. Between mid-August and the end of September, global markets not only gave up their gains from earlier in the quarter but put in fresh lows for the year.


Three thoughts on the economy

First, it’s our view that the Fed is probably over doing it, especially when we consider that today’s inflation is predominately due to supply side constraints and less so demand side excesses (i.e., quantitative easing and fiscal stimulus). If today’s inflation was indeed due primarily to excess demand, the Fed’s year-to-date rate hikes would’ve likely been more successful in bringing it down by now. De-globalization, the war in Ukraine, lingering global COVID disruptions, and COVID-related factory shutdowns in China all point to supply side culpability in today’s inflation fight—factors over which the Fed has no control. Yet there’s growing evidence that supply chains are easing—improved delivering times, slowing growth in the Purchasing Managers’ Index (PMI) input and output prices, and declines in the New York Fed’s Supply Chain Pressure Index all indicate supply chains are slowly improving, suggesting that inflation will likely, in time, ease on its own.

Second, the U.S. economy probably doesn’t have the productive capacity to sustain interest rates at current levels, let alone higher interest rates. Slow growth in the working-age population, combined with anemic real growth in worker output, both suggest the economy has the capacity for growth at a real rate of about 2.1% annually. As a result, sustaining today’s interest rates at current levels for very long seems unrealistic—at least not without pushing the economy (further?) into recession.

Finally, not even the Fed believes it will be able to sustain interest rates for every long at current levels. In fact, the Fed’s long-run projection is for a Fed funds rate of 2.5% (it’s currently 3% – 3.25% and is projected to peak at around 4.6% by late 2023). The Fed’s own dot plot indicates the Fed itself expects to cut rates sometime in 2024. In contrast, the market expects the Fed to begin cutting rates again sometime in 2023. Nevertheless, the Fed and the market agree on one thing—that interest rates will need to come down in the not-too-distant future. It’s just a matter of when, not if.


Implications for investors: perspective, opportunities, and lemons

However, whether one agrees with Fed policy is irrelevant. And both the market and the Fed can (and do) get things wrong from time to time. It’s possible, for example, that rates could remain higher for longer. It’s also possible that the Fed in the near future does a hard pivot and begins cutting rates sooner than expected—or at least slows or halts its plans for future rate hikes. The global economy is infinitely complex, and the future is always unknowable. The more important question for investors is what to do now.

First, we should keep things in perspective—which means tuning out much of the media hype. None of this is to gloss over the pain investors have experienced this year in their portfolios, but the media’s negative framing is not only discouraging, it’s often framed in a way to intentionally elicit an emotional response and results only in making us feel worse. For example, a recent headline exclaimed that the market’s return through the end of Q3 was the “worst start to the year since 1931”.  While technically true, the headline fails to mention what, if anything, makes the first 9 months of the calendar year any more special than any other 9-month period. The headline, for example, could just as easily stated that “the S&P 500’s year-to-date return was the 41st worst 9-month return since 1926”—an also true albeit less dramatic headline. In fact, since 1980, intra-year declines have met or exceeded this year’s year-to-date declines in 9 of the past 42 years (more than 20% of the time or one out of every five years).  The takeaway? While year-to-date returns have certainly been painful, they’re far from unusual.


Exhibit A: Intra-year declines have met or exceeded 2022’s YTD returns in 9 out of 42 years (data through October 3, 2022).

JPM Guide to the Market, October 3, 2022, slide 15. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from peak to a trough during the year. For illustrative purposes only.

Second, we should maintain a long-term perspective. We would be wise to maintain a globally diversified portfolio, one that’s diversified across and within asset classes and styles (i.e., things like value and quality stocks). But why remain diversified, given 2022’s negative returns? Why not just sit in cash and “wait this one out”? Because future market returns are most attractive when markets are at their lowest. Both bond and stock markets are, at today’s valuations, the most attractive they’ve been in many years. The S&P 500 today trades at 15 times next year’s earnings, a roughly 10% discount to its 25-year average; value stocks, a 14% discount; and non-U.S. stocks, a near 30% discount to their 25-year average.2 For income-focused investors, today’s higher yields are the highest in over a decade and a welcome respite from years of near-zero interest rates. While year-to-date losses have been painful for long duration investors, we believe laddered short-duration fixed income portfolios (the bulk of our portfolios, by the way) should recover nicely from recent rate hikes over a couple of years and are well-positioned over the longer term to benefit from today’s higher rates.

Finally, now is always a great time for proactive financial planning, especially tax planning. Tax loss harvesting in taxable accounts, for example, provides very real, tangible tax benefits by way of deductions and/or loss carryforwards. It’s good tax planning to invite Uncle Sam to subsidize your losses. Additionally, now may be a great time for investors to tactically engage in various combinations of Roth conversions (and/or recharacterizations), transferring depreciated assets out of our estates, or front-loading 529 plan contributions. When the market hands us lemons, making lemonade makes all the sense in the world.

1 Source: YCharts, Inc.
2 JP Morgan Guide to the Market, Q4 2022, slides 10, 49

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