By: Darren W. King | Wealth Management
The bear market in equities further intensified in the third quarter, as the fed’s interest rate hiking cycle and tightening of financial conditions increased recessionary probabilities. The S&P 500 fell around 5% during the third quarter. The S&P 500 closed out the first three quarters of 2022 down 23.88%. The Technology-heavy NASDAQ lost 31.98%, while the DOW Jones Industrial Average lost 19.72% through September of 2022. The Russell 2000 Small Cap Index was down 23.45% over the same period. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed September down 27.09% in US dollar terms and lost 14.46% in local currency. The MSCI Emerging Markets Share Price Index closed September with a loss of 20.75% in US dollar terms.
The first three quarters of 2022 saw high valuation technology, internet commerce and growth shares in general lag the overall market. Sector results through 9/30/22: Energy 34.48%, Utilities -6.51%, Consumer Staples -11.83%, Health Care -13.08%, Industrials -20.72%, Financials -21.24%, Materials -23.75%, S&P 500 -23.88%, Real Estate -28.92%, Consumer Discretionary -29.89%, Information Technology -31.44% and Communication Services -39.04%. Rising energy prices saw oil and natural gas levered names lead the market as the only sector posting positive returns while defensive sectors, such as Utilities, Consumer Staples, and Health Care provided some relative safety.
Based on current consensus earnings forecasts, the forward 12-month P/E ratio for the S&P 500 is 15.4X, cheaper than the ten-year average P/E of about 17.1X. Currently, the market is estimating 7.4% earnings growth and 10.7% revenue growth in 2022, but analysts have already trimmed 2022 earnings forecasts down by 2.3% since the end of the second quarter. The average historical S&P 500 trough earnings multiple off peak earnings has been 14.5X. This implies further downside for the S&P 500 in the single digits if we assume earnings will slow with higher interest rates, elevated inflation, dollar currency strength, and reduced economic growth hitting corporate earnings in the future. Forward earnings guidance from managements will be a primary focus in the weeks ahead in order to provide some clarity on rising rates and inflation’s impact to corporate earnings.
During their September 2022 meeting, the Federal Reserve initiating another 75 basis point fed funds rate hike on the heels of the August CPI reading that showed inflation barely slowed from prior months. The August CPI number, came in at 8.72%, despite a 10% decrease in energy prices. The September meeting marked the fifth interest rate hike in 2022, as the fed funds rate now sits at 3.25%. The Fed faces a big challenge as it attempts to raise interest rates while also ending qualitative easing in an effort to stymie inflation, without breaking the economy. Latest economic projections show an economy that is slowing following unprecedented stimulus during the pandemic. GDP grew 6.9% in 2021 and is expected to grow 1.6% in 2022, revised down from 2.8% in March, as inflationary pressures are beginning to slow discretionary spending and eroding corporate profit margins. As measured by the Consumer Price Index, annual inflation rose 8.7% in August and is expected to end 2022 at 7.9%, revised up from 5.1% inflation projections in the first quarter of this year. All in, The Fed is willing to slow economic growth by increasing borrowing costs as it fights historic levels of inflation.
Current forecasts are predicting a Fed Funds Rate around 4.25-4.50% by the end of the year, 150 to 175 basis points higher than first quarter projections. The market has also extended the end of the current hiking cycle out to year-end 2023 from earlier estimates that speculated rates not rising after December of 2022. Additionally, current consensus is starting to price in something greater than a soft landing for the economy. Bloomberg’s one year out recession probability forecast is now 50%, up from 33% at the end of last quarter.
The 10-year treasury staged a historic sell-off during the first three quarters of the year; starting the year at 1.51% and ending the third quarter at 3.83%. Current intermediate treasury rates are now back to levels last seen in 2009. Longest duration bonds underperformed shorter duration issues as yields rose across all maturities. 20+ year treasuries lost 30.14% through September of this year, while intermediate treasuries lost 8.70%. In a risk-off trade, higher credit quality outperformed the lowest credit quality issues. Aaa rated bonds within the Barclays U.S. Aggregate Index lost 13.13% through September, while Baa rated bonds lost 30.14% during the same period.
The Bloomberg Dollar Spot Index strengthened 13.98% in the first three quarters of the year as the Fed initiated five interest rate hikes and currency markets were jolted by the invasion of Ukraine. Light crude oil futures have risen 12.9% in 2022 as the Ukrainian invasion further constricted oil and gas supply. WTI oil futures rose from $70.38 at the end of 2021 to $78.38 at the end of the quarter but have fallen from the highs of $112 seen in June of this year. 30-year mortgage rates rose from 3.27% at year-end 2021 to 7.06% at the end of the September, while 30-year treasuries rose 188 basis points from 1.90% at year-end 2021 to 3.78% at the end of the third quarter.
According to the Bureau of Labor Statistics, the August employment report showed 315k jobs gained during the month. The report surpassed estimates for a gain of 300,000 jobs. The August Jobs number reported unemployment at 3.7%, approaching the February 2020 pre-pandemic rate of 3.5%, a 50-year low. The labor force participation rate in August was 62.4%, up from the pandemic trough of 60.2% in April of 2020. More people entering the workforce following the pandemic is an aid in reducing the tightness of labor markets and assists in further cooling of monthly wage growth. For August, hourly earnings rose 5.2% while August job openings fell to 10.1 million from 11.2 million in July; further suggesting labor demand is moderating.
Retail sales in August increased .3% from the prior month and marked a reversal from July’s .4% decline. Annualized retail sales were up 9.1% over the past year compared to the consumer price index’s measure of inflation up 8.7%. Gasoline sales’ hit to discretionary spending was still evident with a of 29.3% increase from the prior year but was down 4.2% from the prior month. Department store sales rose .7% from the prior year. E-commerce and mail-order houses ended the 12-month period with a 11.2% sales gain. Auto sales were up 6.5% from the prior year. Restaurant spending was up 10.9%, furniture store sales were down 1.6%, health care spending was up 1.5% and clothing and accessories were up 3.5%. Despite a return to spending on restaurants and services, we expect real consumption growth to slow over the coming months, especially for big-ticket items related to housing.
As feared, equity markets did not hold trading levels experienced after the original market low in June and continued to decline across the second quarter. While forward P/E multiples have come down following this year’s market correction; a key question is have they come down enough to discount a confluence of economic challenges?
One reason for our caution is the disconnect between Wall Steet analysts, who have yet to price in any appreciable decline in forward earnings estimates for this year or the next, with Wall Street strategists who are not yet convinced that current projections will hold. We prefer to wait on the real possibility for downward earnings revisions, beginning with this quarter’s earnings season, before getting more constructive on equity markets. However, equity markets have discounted a considerable amount of economic uncertainty during the current bear market and are well through most of this painful correction.
Within the fixed income markets, March initiated a major shift in Fed policy as interest rate liftoff began in March while Fed meeting notes indicated $95 billion in monthly runoff of their $9 trillion bond portfolio beginning in May. With core inflation running above 8%, the path to higher interest rates has moved significantly since the beginning of the year. Treasury market rates have shot up following these developments as the 2-year treasury started 2022 at .73% and has risen to 4.09% today. The 10-year treasury rose from 1.51% at year end to 3.61% today while the 30 year treasury has moved from 1.90% to 3.69%. Fixed Income market strategists now see the fed funds rate hitting 4.25% to 4.50% by year end, while remaining around 4% well out to 2024. The Moody’s Seasoned Aaa Corporate Bond yield, currently at 4.91%, is at the highest levels seen in a decade. In our opinion, the fixed income markets now offer yields that provide an alternative to equity only investing that has not presented itself in the last decade’s low interest rate environment. They also offer defensive positioning to higher probabilities for a coming recession and the potential for lower corporate earnings in the near term.
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Click here to read the Q3 2022 Market Summary.
Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.