Investment Insights Amid Market Volatility
Nowhere to Hide
This year’s market volatility has been spread across risky assets and safe havens alike, leaving investors to ponder where to hide from further pain. Outside of broad commodities and cash, most major asset classes have experienced double-digit losses year-to-date. The S&P 500 has fallen 23.9% this year, with all three major U.S. stock indexes (S&P 500, Dow and Nasdaq) declining for a third consecutive quarter and headed for their worst annual performance since the Great Financial Crisis in 2008. Perhaps the most discouraging twist in 2022 is that bonds have fallen alongside stocks. Throughout history, a combination of stocks and bonds has enhanced the diversification benefits of a portfolio. Bond prices tend to be more stable than stock prices, and this relative stability has often helped to insulate a portfolio during times of market stress and smooth out performance over time. Unfortunately, in the current environment of rapidly rising interest rates and persistent inflation, the usual benefits of diversification have been neutralized to some extent. Thankfully for investors, history tells us that instances of stock and bond prices retreating in sync have been few and far between. According to Wells Fargo Investment Institute, they observed only six calendar years since 1929 in which both stock and bond prices declined on an annual basis: 1931, 1946, 1969, 1973, 1977 and 2018.
From Summer Rally to Fall Flop
Stocks began the third quarter on a high note as the S&P 500 jumped 9.2% in July, marking its best monthly performance since November 2020. The rally continued through mid-August with stocks up 14% for the quarter, clawing back roughly half the market’s losses through mid-June. The strong move higher, coupled with expectations that inflation may have peaked, had investors hoping the worst was over and a new bull market had begun. Ultimately, inflation proved persistent rather than transitory as the August Consumer Price Index (CPI) report came in hotter than anticipated. As inflation continued to run above target, a fifth rate increase from the Fed in September and growing fears of recession sent stocks tumbling 16.7% and back into bear market territory by the end of the quarter.
Beyond large cap stocks, which declined 4.9% (S&P 500) for the quarter, smaller capitalization stocks fared slightly better as the S&P 400 Mid Cap index declined 2.5% and the Russell 2000 small cap index fell 2.2%. Outside the U.S., stocks were even more volatile as a surging U.S. dollar, an energy crisis in Europe, and looming recession fears globally forced international developed and emerging market stocks lower by 9.3% (MSCI EAFE) and 11.5% (MSCI EM), respectively.
Higher Rates and the Economy
The Federal Reserve hiked the Fed funds rate by 0.75% in September to a range of 3.00% to 3.25% and reiterated its resolve to fight inflation even at the risk of causing below trend economic growth. At quarter end Federal Funds futures contracts signaled the potential for rate increases of an additional 1.25% by year end, but the degree to which those additional increases materialize will depend on inflation data over the next three months.
In response to persistent inflation (headline CPI clocked in at 8.3% year-over-year in September) and aggressive Fed tightening, U.S. Treasury yields rose to multi-year highs. The 10-year Treasury yield rose 0.82% for the quarter, with a closing high of 3.95% on September 27th before falling to 3.84% at quarter end. The yield on the 2-year Treasury rocketed even higher, by 1.32%, ending the quarter at 4.22% and up from just 0.27% one year ago. With the largest yield increases among short maturities, the yield curve is now significantly inverted marking a commonly cited indicator of a potential recession over the next 12-18 months. Given the inverse relationship between bond prices and yields, the Bloomberg U.S. Aggregate bond index declined 4.8% for the quarter, on par with losses experienced in the broad equity market.
Over the course of the third quarter, economic data began to show evidence that the Fed’s efforts to slow the economy were taking effect. Existing home sales fell for the seventh consecutive month in August as affordability declined due to mortgage rates above 6% and elevated home prices. In September, the ISM Manufacturing index declined to 50.9, just above contraction territory as data on new orders and backlogs slowed more than expected. Even despite these signs of slowing, the U.S. labor market remains a bright spot for the economy. Employment rose by 263,000 in September, and at 3.5%, the unemployment rate is now down to its pre-pandemic level. A strong labor market is crucial for the U.S. economy because consumer spending accounts for roughly 70% of GDP.
Alternative Assets
Alternative assets generally outperformed both stocks and bonds during the quarter, fulfilling their diversification purpose. The only exception was Real Estate (as represented by the FTSE All Equity REIT Index) which lost 10.8% during the quarter. Broad commodity prices dropped 4.1% but are still up 13.6% year-to-date. Lastly, the global hedge fund index outperformed stocks by a healthy margin with a gain of 0.6%.
Don’t Lose Sight of the Goal
It is easy to lose sight of our financial goals during periods of market volatility. Emotional reactions to market events are normal, but actions taken during such periods can make the difference between investment success or failure.
Creating a thoughtfully constructed investment plan and sticking with it is critical to achieving both short and long-term goals. If you have questions or would like to review your plan, please reach out to a member of your Broadway Wealth Management team.
For questions or comments on any of the topics included in this newsletter, please contact Broadway Bank’s Wealth Management team at [email protected].
