Real GDP finished the quarter in positive territory at an estimated annual rate of 2.6%; however, underlying growth remains sluggish, and the threat of an impending recession appears more likely.
The labor market remains strong with the unemployment rate back down to 3.5% and anticipated to remain under 4% for the remainder of the year.
Consumer spending increased in August and September but has definitely softened in 2022, shifting away from goods and into services.
Corporate earnings remained positive in Q3 but have moderated considerably throughout 2022 as corporations face a host of headwinds, including the rising costs of labor and inputs.
Inflation continues to surge with the Consumer Price Index at 8.2% year-over-year.
The US dollar has strengthened to highs not seen since the mid-1980s, which negatively impacts US exporters and exacerbates inflation for other countries.
The Federal Reserve continues to maintain its hawkish stance on fighting inflation and has entered its fastest rate hike cycle since 1980.
With surging inflation, threat of recession, and aggressive monetary tightening, equity markets added to their losses falling further in Q3. The S&P 500 ended the quarter down -24% year to date.
Rising rates have pushed bond yields to multi-decade highs and eroded prices in nearly every sector of the fixed income markets.
After a slew of government spending in 2021, fiscal stimulus and the surge from post-pandemic reopenings have faded leading to a contraction in real GDP for the first two quarters of 2022 ( -1.6% in Q1 and -0.6% in Q2). While Q1 showed robust consumption and business spending, the trade deficit widened, offsetting strong domestic demand. In the second quarter, multiple factors negatively impacted growth including record high inflation numbers and Russia’s invasion of Ukraine. We saw large declines in goods industries, both residential and non-residential construction, equipment spending, and inventory rebuilding. Though personal disposable income was up 5.7%, once adjusted for taxes and inflation, real disposable income declined -1.5% in Q2.
Real GDP growth in the third quarter, is estimated at approximately. 2.6%, suggesting that the economy is not yet in recession. However, underlying growth has been much less robust and signals trouble ahead. Q3 growth was led by net exports, particularly in the goods sector, where exports surged and imports fell. However, core GDP, the combo of personal consumption, business investment and homebuilding, rose at a meager 0.1% pace. Real personal consumption was up approximately 1.4% but moving forward it’s difficult to be optimistic about growth with inflation surging and savings falling. The debate of when the economy will enter a full-blown recession will continue, even as the Fed tries to engineer a “soft landing”. But it appears likely that economic weakness will intensify and spread more broadly throughout the economy over the coming months.
Despite sluggish and moderating growth, the labor market remains strong and is perhaps the key roadblock in preventing a recession during 2022. The most recent report showed 263,000 jobs added in September, after 315,000 were added in August, pushing unemployment back down to 3.5%, matching all-time lows dating back to 1965. Job openings also remain near all-time highs, at 11.3 million. There are almost two times as many job openings as unemployed workers. Such a wide discrepancy in supply and demand can be attributed to many factors, including the vast majority of baby-boomers retiring and a decreased participation in the labor force.
Higher interest rates and surging wage inflation should eventually weigh on the labor markets as businesses face steeper costs and eventually begin to cut back on hiring. However, we haven’t seen this come to fruition just yet. Business owners are reluctant to let go of employees, even as costs increase and profits fade, as it has proven extremely hard to rehire skilled employees in this post-pandemic environment. That being said, labor markets are historically a lagging indicator. Generally, the economy will weaken and face recessionary headwinds before unemployment significantly accelerates.
We expect the labor data to remain solid in Q4, with unemployment below 4% for the remainder of 2022. However, employment reports may get even more attention than usual, and even a slight deterioration could trigger further market volatility as the economy monitors this key metric through a tightened lens.
Overall real consumer spending growth has softened, and we continue to see a transition from goods to services. After declining in July, we saw a better-than-expected increase in spending for the months of August and September. The post-pandemic revenge spending, though still a factor, is beginning to fade. Many consumers are finally looking at ways to cut costs. In August, spending on services increased, with a modest decline in consumer goods purchased. Within services, healthcare and transportation were the leading contributors to the increase, whereas a decline in vehicle and recreational purchases slowed consumer spending on goods. We are seeing signals that expenses are beginning to shift away from discretionary goods and toward necessities. Retail sales were flat in September, and up 8.2% from last year. Core sales, which exclude the most volatile categories of autos, building materials, and gas stations, rose 0.4% in September and remain up 7.5% year-over-year. That being said, inflation is up approximately 8.2% from a year ago, which mean “real” (inflation-adjusted) spending is essentially flat year-over-year.
On average, the personal savings rate for Americans, from 1959 to 2022, has been 8.9%, peaking in April of 2020 at 33.8%. As the post-pandemic economy has reopened and the prices of goods have greatly increased, it’s not surprising that we’ve seen an exceptionally sharp decline in savings, down to a rate of 3.1% as of this September. Going forward, we expect retail sales will struggle to keep pace with inflation, while overall consumer spending increases modestly, primarily in the service sector, as consumers continue to shift their preferences away from goods and back to services.
Following a spectacular 2021, in which corporate profits increased by 22.6% and S&P 500 operating EPS increased by 70%, it’s not surprising that profits are growing much more modestly in 2022. Analysts predict year-end 2022 earnings growth of roughly 8%. After falling -2.5% in Q1, corporate profit results surprised to the upside in Q2, growing 6.2% for the quarter and up 5.0% year-over-year. Corporate profitability measures total earnings kept, after accounting for expenses, from current production of U.S. corporations. It’s often closely watched as a key economic indicator representing corporate financial health.
Over the past decade, low interest rates, corporate tax cuts, muted wage growth, and low inflation have substantially boosted profits and consequently stock market returns. Currently, however, corporations are facing a host of headwinds including rising rates (cost of debt), increasing labor and input costs, and a weakening consumer. We now seem to be experiencing the long-time anticipated slowdown in corporate profit growth. With a potential recession looming, corporate earnings may see even further deterioration with revenues decreasing as consumers spend less.
For Q3 2022, about 52% of companies in the S&P 500 have reported actual results (as of 10/28/22). The magnitude of positive earnings thus far in Q3 has been below recent years. Of the companies reported, 71% have reported EPS above estimates, which at first glance may seem solid, but the 5-year average is 77%. Thus far, companies are reporting earnings that are 2.2% above expectations. This surprise percentage is below the 5-year average of 8.7%, and the 10-year average of 6.5%. For Q3 2022, the blended earnings growth rate for the S&P 500 is estimated at 2.2% and is expected to continue decelerating for the remainder of the year, 0.5% in Q4 and 6.1% for the full calendar year.
Inflation has been at the epicenter of economic and policy uncertainty and has driven significant market volatility in 2022. After being relatively stable at approximately 2% for the past 25 years, inflationary pressures have skyrocketed in 2021 and 2022, driven by a plethora of variables including surging consumer demand (fueled by fiscal stimulus), a sizeable increase to the money supply (due to accommodative monetary policy), and severe global supply shortages across all major economic sectors. Heightened geopolitical risks further exacerbated inflation this year as the Russian invasion of Ukraine caused spikes in energy and commodity prices, and China’s “zero-tolerance” policy towards COVID bogged down supply-chains. In June, the headline annual inflation rate reached 9.1%, which economists will hope to call the official peak of inflation in the coming months.
Prices moderated somewhat in Q3, with the Consumer Price Index (CPI) finishing the quarter at 8.2% year over year. A small moderation in energy prices was the primary contributor to headline inflation’s decrease throughout the quarter; however, energy prices are extremely volatile and are still up 19.8% from last year. Food prices have risen 11.2% from last year. Even if we strip out the volatile sectors of energy and food, the Core CPI was up 6.6% year over year. A broad range of categories contributed to the rise, most notably: housing rents, medical services, education, vehicle insurance, and new vehicles. Housing rents, a key driver of inflation (comprises 30% of the CPI), have continued to accelerate in 2022, posting the largest monthly increases in more than thirty years. We expect this trend to continue in 2023 and 2024 as rents still have a long way to go to catch up to home prices, which swelled during the pandemic.
While the inflation story began with specific one-off narratives, it is clearly now pervasive throughout the economy – outpacing wage gains and putting real strain on household budgets. Even if prices have peaked, they still have a very long way to go to get back to the Fed’s 2.0% target. The Fed recently projected 2.8% inflation in 2023. While there may be pockets of relief or moderation, we expect inflation to be far stickier than this, ending 2022 at approx. 8% and likely moderating to 4-6% in 2023.
The inflation outlook remains one of the key obstacles to economic growth in 2022 and 2023 and the primary factor affecting the financial markets. Developed nations across Europe are experiencing similar or worse levels of inflation relative to the U.S. While the near-term forecast is challenging, economists agree that inflation is expected to cool over the coming years, regardless of a consequential recession.
The U.S. dollar soared in Q3 to multi-decade highs (since 1985) against multiple currencies. The dollar’s strength is supported by geopolitical fears, the war in Ukraine, and the Fed’s aggressive rate hikes relative to other central banks. A strong dollar has global implications and, in many ways, can be a headwind to US growth, acting on the economy in a similar way as higher interest rates. A strong dollar is detrimental to US exporters, as goods become relatively more expensive to the rest of the world. A stronger dollar also impacts large multinational corporations that rely on revenue generated abroad. The revenue is worth less, once repatriated. Additionally, nearly all commodities are priced in dollars. This means inflation in commodity prices is magnified in international markets. The price of oil YTD in the U.S. has risen 11%. However, if paying in Euros, the price is up 28%, and in British pounds, up 35% YTD. One can easily see the effects of a strong dollar on a global scale.
In order to combat extreme and persistent inflation, the Federal Reserve doubled down on its hawkish trajectory in Q3, entering its fastest rate hike cycle since 1980 and unwinding accommodative monetary policy with aggressive tightening. Following an unofficial “peak” inflation reading in June, the Federal Open Market Committee (FOMC) meetings in July, September, and November each resulted in 75 basis point rate hikes, bringing the benchmark discount rate to 4.00%, for the first time since 2008. The impact of those decisions sent shockwaves through financial markets, as investors adjusted inflation expectations and interest rate forecasts.
Through the end of 2022, the Fed’s dot-plot, a projection report of future rates, anticipates further rate hikes of 50 bps in December. In 2023, the Fed has gestured at more rate hikes totaling 50 bps, and then it expects to begin rate cuts as early as 2024. These forecasts are taking into consideration unemployment projections of 3.8% for 2022 and 4.4% holding in 2023 and 2024. However, many analysts believe that the Fed’s economic outlook may be too optimistic. Fed Chair Jerome Powell’s tone has reflected this assertive stance to combat inflation as he has reinforced the FOMC’s commitment to bring rates to a restrictive level. The financial environment has changed significantly since rate hikes and quantitative tightening began, but the economic effects may take months to fully surface. As the Fed turns more hawkish, the pathway to avoiding a recession narrows and the prospect of achieving a “soft landing” appears less plausible. Given that the Fed may not yet have reached peak hawkishness, we expect jobs and inflation data to be flashpoints for heightened volatility in the coming quarter.
While the $5.3T of stimulus legislation passed throughout the pandemic helped accelerate the economic recovery, it left behind a wake of inflationary pressures and a ballooning fiscal deficit. Distortions of economic activity continue to linger as trillions of dollars in stimulus from the pandemic have not been fully processed by the system.
The Inflation Reduction Act was passed into law by the Senate in August of 2022. The legislation seeks to accomplish a scaled-down version of the Biden administration’s Build Back Better Act. The main provisions of the act aim to reduce the federal deficit, enable Medicare to negotiate drug prices and invest in sustainable energy. According to the White House, this law will make “the single largest investment in climate and energy in American history.” Means to raise funding for this bill include a new 15% minimum corporate tax rate and an enhanced IRS tax enforcement program. While the Inflation Reduction Act boasts a catchy and relevant name, the Congressional Budget Office estimates it will have a “negligible effect on inflation” in the near-term and could even nudge it upward. The CBO does estimate it will decrease the deficit by more than $100 billion over the next decade, which represents only 4% of the 2021 budget deficit.
U.S. equities slumped into a bear market during the first half of 2022 as investors worried about inflation, aggressive monetary tightening, heightened geopolitical risks, and the threat of recession. The S&P 500 began Q3 with a refreshing July increase, erasing some of the disastrous Q2 losses, as investors increasingly priced in Fed rate cuts in 2023. But, it wasn’t long before investors gave up hope that the Fed would pivot from their hawkish stance and realized this was nothing more than a bear-market bounce. The index ended the quarter with a -4.9% loss, bringing YTD losses to -23.9%. Of the 11 primary economic sectors only two of them finished positive for the quarter – consumer discretionary and energy, up 4.4% and 2.2%, respectively. Not surprisingly, energy has been the only positive performing sector year-to-date. Communication services and real estate where the two greatest detractors this quarter, falling -12.7% and -11.0% respectively.
The NASDAQ Composite, dominated by information technology stocks, finished the quarter with a loss of -3.9%, and is down -32% YTD. Our cooling economy has been exceptionally hard on tech. Pandemic driven stocks, which surged in 2020 and 2021 suffered a harsh reality check in 2022. Companies such as Zoom and DocuSign experienced losses of as much as 70 to 80% off their highs. Compressed valuations continue to push investors away from “high-flying” growth stocks and toward value plays and quality names, supported by strong balance sheets.
Developed and emerging international markets have also experienced a rough ride in 2022, with losses slightly greater than domestic markets. The MCSI All World, Ex-USA Index fell by -9.9% in the third quarter, down -26.5% YTD. Considering these steep declines and current valuations, many investors are optimistic international equities are attractively priced and poised for solid future returns. That being said, international economies are facing even stronger headwinds than the U.S. with exacerbated inflation from a strengthening dollar, and more are more vulnerable to impacts from of the Russia / Ukraine war and China’s Zero-COVID policies.
The continued market sell-off caused valuations to compress further in Q3, with all major equity valuations below their long-term averages. The S&P 500 forward P/E ratio is now sitting at at the end of Q2 and just below its 25-year average of 16.8x. Though no one can predict the bottom, it appears that after the recent correction, the market is more “fairly valued” and a lot of the bad news may already be baked in. That being said, though current valuations do not appear excessive on the surface, a resetting of investor earnings expectations could necessitate another wave of market repricing and further volatility. With elevated inflation, a potential recession approaching, and more rates hikes on the way, equities are likely to remain volatile in the coming months, and we may see further deterioration across financial markets.
Consumer sentiment is at a 10-year low, perhaps indicating reasonable entry points for equities may be on the horizon. The University of Michigan Consumer Sentiment Index highlights eight distinct peaks and troughs in consumer sentiment dating back 50 years. On average, purchasing during a confidence peak resulted in a 4.1% return over the following 12 months, while purchasing at a confidence trough yielded a 24.5% return. This investing strategy aligns with a well-known quote from Warren Buffet, – “be fearful when others are greedy and greedy when others are fearful.”
Private equity markets continue to hold strong as they are not forced sellers and the returns on investment are more reflective of true economic performance and less of investor sentiment and fear. Private equity firms have been deploying built up cash on companies trading at more moderated prices. Illiquidity in the private markets, which can sometimes be perceived as a drawback, often provides price stability during volatile markets. This has been very evident in 2022, with top quartile private fund managers posting minimal losses YTD, and in many cases gains. Much of the value-add experienced in private equity reflects operational and financing restructure, and M&A opportunities brought forth by the fund managers. Private equity firms thrive by providing real value in investment cycles, an opportunity for investors to reap the benefits of active management.
Fixed Income Markets
Since 1926, 2022 has been the worst start to a year for bond markets, as high inflation and low unemployment resulted in an extremely hawkish Fed. Aggressive rate hikes have driven bond yields to multi-decade highs eroding bond prices and steepening the yield curve inversion. The 2-year Treasury yield spiked 124 basis points in Q3, surpassing 4% for the first time since 2008, while the 10-year grew by 77 basis points, hitting 3.80 by the end of the quarter.
Bond prices have fallen in nearly every sector of the fixed income markets, with historic declines in interest rate sensitive core fixed income. The Barclays US Aggregate Bond Index fell -4.8% in Q3, bringing losses for the year to -14.6%. Municipal Bonds are down -12.6% thus far in 2022, and the US Corporate Bond Index has posted losses of -18.3% for the year. Leveraged Loans were the only category with positive returns in Q3, up 1.4% and are down only -3.3% in 2022. Credit spreads have risen considerably this year across all categories and are now above their historical averages, but with bond yields still historically low, there is little to cushion price declines.
Until inflation has subdued, the outlook for core fixed income remains dim. In the short-term, credit sensitive fixed income will continue to trade along equities and broader risk assets, likely meaning more volatility. But in the longer-term, the credit market is supported by strong fundamentals, like solid margins and earnings that have surpassed pre-COVID levels. Default rates remain near record lows, leading some analysts to believe that the debt market is well positioned to weather the storm.
After delivery a strong post-pandemic recovery, the global economy is teetering on the brink of recession. Historically high inflation and tight labor markets have induced extremely aggressive policy responses from central banks. We seem to be settling into a new era of higher macroeconomic volatility, as geopolitical risks continue to rise and threaten global supply chains and energy prices. With a shortage of workers, rising prices, low consumer sentiment, and softening earnings, economic weakness is likely to intensify and spread over the coming months. The Fed has downgraded GDP growth projections to 0.2% for 2022 and the probability that a true recession will emerge in 2023 is high.
We anticipate continued volatility in the financial markets as investors brace for what could be a not-so-soft landing. While headlines continue to cast a gloomy outlook, debt markets report strong fundamentals and, in our opinion, global equity valuations appear increasingly attractive for the long-term. Investors tend to see short-term volatility as the enemy, but history has shown that those who chose to stay the course tend to be rewarded for their patience, more often than not. Many are tempted to move money out of the market and “sit on the sidelines” until things calm down. Although this may appear to solve the problem or numb the pain, it creates several others – timing when to get back in, missing a potential rebound, inflation eroding your purchasing power while you’re waiting. We believe the wiser course of action is to review your plan with your financial professional and remain disciplined in your portfolio strategy to accomplish your financial goals.
Chief Investment Officer
|Taylor Snider, CFP®
- BlackRock – Global Outlook in charts
- First Trust – Money Morning Outlook 10.03.22& 10.10.22
- FS Charted Territory Inflation Playbook
- FS Charted Territory Inflation Playbook
- FS Economic Outlook Struggling for a foothold
- JP Morgan Economic Update
- JP Morgan – Guide to the Markets
- PMC Quarterly Economic and Market Overview
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The MSCI ACWI ex USA is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Index consists of 46 country indices comprising 22 Developed Markets, including Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom; and 24 Emerging Markets, including Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Peru, the Philippines, Poland, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
The S&P 500 Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization.
The Bloomberg US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.