Q3 2022: PFM Quarterly Commentary
Would you ever consider running a humidifier and dehumidifier at the same time in the same room? No reasonable person would. We can use this silly question to conceptualize how fiscal policymakers and monetary authorities the world over are undertaking, in a financial sense, the very same futile action in their uncoordinated efforts to solve today’s two greatest economic problems: pervasive inflation and stagnant economic growth. In fairness, before we haphazardly judge them too harshly, let’s first understand just how complicated and historically unprecedented the circumstances of the current situation are. You’ll quickly see why it’s no surprise that policy missteps are being made.
The third quarter began after the worst performance for domestic bonds since before George Washington was inaugurated, the deepest selloff for global bonds since before the Civil War, and maybe most striking of all, the poorest six-month start to the S&P 500 – ever. Further abetting negative investment sentiment was a confluence of factors: the U.S. experiencing its highest inflation in four decades, slowing global growth, seasonality headwinds, and monetary tightening in full swing. Navigating any one of those issues would be challenging; tackling them simultaneously has driven those in power to try unconventional, if not desperate actions. As a result, some of these problems were addressed marginally during the quarter, but to the world’s chagrin, many worsened, and new ones emerged.
During the period from July 1st through September 30th, the Federal Reserve raised the Federal Funds Rate (the rate at which commercial banks lend their excess reserves to each other overnight and the only interest rate the Fed directly controls) by 1.50% to a new range of 3.00% to 3.25%. Other major central banks joined the monetary tightening party, including the European Central Bank (ECB) which raised interest rates in July by 0.50% (the first increase in eleven years) and then did so again by another 0.75% in September. The Bank of Canada continued raising its interest rates, adding a further 1.75% in the quarter, while the Bank of England tacked on an additional 1.00% to its lending rate. This wave of aggressive rate increases certainly had the desired effect of slowing global economic activity. Unfortunately, inflation remained stubbornly high stoking fears of stagflation, a condition of low or negative economic performance with persistently high inflation – the worst possible outcome for central bankers.
The inflation today stems from constrictions in supply of both labor and materials, not excessive demand and/or currency devaluation. The most traditional tool of central banks to combat rising costs, interest rate hikes, tend to have little impact on this supply-side inflation and can disproportionately slow the economy as a side-effect. Accordingly, despite the Fed’s most aggressive tightening program in generations, the most widely used measure of inflation, the Consumer Price Index (CPI), stubbornly reported 8.3% (annualized) for August even though the price of crude oil fell 25.3% in the quarter. At the same time, job cut announcements rose 58.8% year-over-year, multiple job holders reached an all-time high, home prices fell for the first time since 2012, the homebuilder index recorded its second largest drop on record, the U.S. entered a recession, the ISM Index measuring the national health of the service economy fell by the largest amount on record, the small business optimism index registered its lowest reading in its 48-year history, home affordability plummeted as mortgage rates crossed above 7.0% for the first time since 2000, and the investment markets turned in their worst performance in recent memory. We understand that any effects from shifts in monetary policy aren’t instantaneous, but up to this point in the tightening cycle, it seems that the efforts by central banks to rein in inflation has impacted everything but inflation.
Clearly, investors observed these developments and reacted. Markets in 2022 now hold some infamous distinctions which can offer context on this year’s decline in almost every investment sector. For example, with one quarter left this year, 25% of all trading days to date have seen a drop of 1% or more in the S&P 500. This statistic has only occurred twice since World War II, in 2008 (30%) and 1974 (27%). Similarly, 2022 has featured six 3% monthly declines in the S&P 500 – and three months remain. Only 1931 and 1937 had more 3% monthly declines, with seven each. Finally, if we look at rolling nine-month periods with -3% monthly returns, 2022 joins late 1974 and early 2009 with the rare honor.
This update on the recent state of affairs brings us back to our humidifier and dehumidifier analogy. Clearly, governments and monetary authorities have taken notice of the turmoil in the financial markets. In turn, they have introduced stimulus measures to encourage economic growth and stabilize both the investment markets and important global currencies, all the while contemporaneously reinforcing their existing commitments to further tighten monetary policy. Ironically, it was the unprecedented global stimulus that flooded markets following the Great Financial Crisis that predominantly contributed to our current inflationary plight. Past mistakes remain unheeded, as Congress recently passed the Inflation Reduction Act, which many studies, including one undertaken by the Wharton School of the University of Pennsylvania, have concluded will instead likely worsen inflation. Similarly, the current Administration just proposed $400 billion of student loan forgiveness which some leading economists like Larry Summers warned will only exacerbate inflation. For decades now, Washington has spent (and borrowed) generously without considering the downstream inflationary effects.
The rest of the world is similarly struggling with their own policy responses. The European Central Bank announced a program in August that provides quantitative easing (stimulus) for some countries in the European Union and quantitative tightening for others. The Bank of Japan launched its first currency intervention program in late September to buoy the Yen after it reached its lowest level in 27 years against the dollar. Lastly, the Bank of England shocked markets with a new unlimited bond buying stimulus program, the very definition of quantitative easing, just one week after it began a quantitative tightening program which included further interest rate increases. In summary, major central banks around the world continue their tight monetary policies to combat inflation while simultaneously providing massive amounts of stimulus which in turn increases inflation. The humidifier and dehumidifier are running full tilt.
While we, nor anyone for that matter, can reliably predict the future, there are reasons to be hopeful despite the prevailing storm clouds. First, we’re about to enter what’s traditionally known as the “sweet spot” in the well-documented four-year market cycle that coincides with a Presidential term, a period where equity markets tend to provide solid gains. Second, October, despite its reputation for poor market returns, actually is the fourth best performing month of the year. And October has what’s possibly an even more important attribute: it has served as “the bear killer.” It’s been the pivot point of twelve bear markets since World War II – seven of which were midterm election years like this one. Third, the widely followed American Institute of Individual Investors (AAII) Sentiment Survey in mid-September reported that 60% of its respondents were bearish for only the fifth time in its 35-year history. Returns by the S&P 500 one year after the previous four occasions were 22.4%, 31.5%, 7.4%, and 56.9%. Fifth, bearish positions in the options market (a leveraged derivative market often used by institutions) hit their largest number in history, widely considered a contrarian bullish indicator for decades. The previous record of bearish options positions was June 17, 2022. This marked the last major low this year with the S&P 500 shortly thereafter rallying 20% over the next two months. Finally, central banks continue to capitulate as they accept that their traditional tightening method, raising interest rates, is disproportionately harming the economy.
These are challenging times. As fellow investors and stewards of your hard-earned capital, we understand your disappointment and frustration from this prolonged market correction. However, having collectively witnessed dozens of market declines of all shapes and sizes over the years, we remain encouraged. The markets have proven their resiliency after each previous downturn. You’ve heard us say on many occasions that the investment markets are undefeated and there is little evidence to suggest that anything has changed in that regard. What also has not changed is our steadfast commitment to manage your portfolios in all market conditions, with diligence and care.
As always, if you have any questions or think we can be of assistance, please let us know. We’re always available.
Peak Financial Management
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