Investment Letter

3rd Quarter 2022

The economic and investment story through three quarters of 2022 can be summarized as a period of global challenges.  Slowing economies, elevated inflation pressures, aggressive monetary policies, recession fears, currency imbalances, energy shortages, and a prolonged war in Ukraine have fueled pessimistic conditions in the U.S. and abroad.

As a result, financial markets have been on a roller coaster ride.  The latest quarter provided an example of the increased short-term volatility as the S&P 500 Index experienced closing price movements of at least 1.00% up or down on thirty (30) individual trading days.  The choppy movements back and forth left investors with no clear picture of where the markets are headed.

A summer rally for equites did provide investors with a glimmer of hope but those dreams faded quickly, and positive momentum gave way to uncertainty and a return to bear market conditions.  The breadth of negative returns meant investors had no shelter from the 3rd Quarter storm as stocks, bonds, commodities, and real estate all ended the period with losses. 

Unfortunately, the 2022 total return numbers through the 3rd Quarter still reflect significant declines in most areas.  See the bond and stock index return numbers below.   

Positive returns were scarce during the first nine months of 2022 and limited to cash, energy, and commodities. 

Elevated inflation continued to be a major headwind for the domestic economy, and slower Gross Domestic Product (GDP) was reported for the second consecutive quarter (-1.6% in QT1 and -0.6% QT2).  The decrease in GDP reflected decreases in private inventory investment, residential fixed investment, and spending by federal, state, and local governments.

The Federal Reserve’s most recent Beige Book report confirmed economic data and conditions varied across some districts with slowing or weak demand being attributed to higher interest rates, inflation, and supply disruptions.  The Fed also stated that overall labor market conditions remained tight, price growth remained elevated, discretionary spending was lower, manufacturing activity was steady, travel and tourist activity rose, transportation activity was mixed, housing market activity was weaker, residential real estate lending declined, drought conditions were causing agriculture challenges, and concerns about weaker demand were growing.[1]

The Fed continued to battle the inflation monster during the recent quarter with its ultra-aggressive monetary policy tightening strategy.  The third straight increase of 0.75 basis points for the federal funds rate was implemented by the Federal Open Market Committee (FOMC) in September to bring the 2022 increase up to 3.00% (fastest rate hike cycle in modern history).  In addition, the FOMC planned to reduce its balance sheet holdings further and monitor a wide range of incoming information for implications on the economic outlook.  As conditions evolve, they are prepared to adjust monetary policy as needed to attain their goal of maximum employment and returning inflation to a two percent long run objective.

The economic picture is not as strong as we have grown accustomed to in previous periods, and there are many reasons to have a pessimistic outlook.  Short-term, we think the current economic and financial rough patch will linger, and we believe inflation data will act as a key driver for the duration of instability.  The Fed has been clear and unwavering with their message about inflation. Investors should expect a continuation of rate hikes to bring down inflation at the cost of decelerating growth.  We expect to see two more substantial rate hikes this year at the November and December meetings, which will likely result in additional volatility and uncertainty.  Despite negative domestic conditions, we are eternal optimists, and we consider the financial health of consumers a tremendous asset that can be an economic life preserver until more favorable conditions return.  The cumulative impact of the 2022 rate hikes will eventually stifle inflation, and we believe the markets will react favorably as the information lag in the economic data catches up.  Looking at a longer-term horizon, we think falling economic indicators will have a positive effect on a potential recessionary environment.  Common sense says that it is harder to get injured when you only fall a short distance, and we believe these softer conditions will make the upward transition in the economic cycle easier.

The impact of falling asset prices on investor portfolios is always a challenge, and significant declines are a test of internal fortitude.  It is easier to sit on the sidelines in times of market uncertainty, but not staying in the game means an investor could potentially miss out on a significant recovery that often follows tumultuous periods.  History has shown bear markets eventually turn into bull markets that achieve new highs, and there is no reason to believe it will not happen again.  While no one can predict how low markets will fall or when they will start climbing again, the current situation tends to lead us to the assumption that a good portion of the negative economic news has already been priced into the financial markets.  This doesn’t mean prices won’t go lower on new data, only that we are optimistic that the current news won’t impact us further.