October 5, 2022 by Ethan Gilbert
An old joke on Wall Street is that the Chair of Federal Reserve is the most powerful person in the world. To many it’s no longer a joke. If there are whispers the Fed may not hike as aggressively, all asset classes seem to rally together and if we get hawkish language from the Fed, everything drops in value.
Unfortunately for investors, 2022 has been the year of the hawk. Jerome Powell has made it clear the Fed will not stop raising interest rates until inflation cools considerably. Thus far, data is not suggesting it has. The widely followed Consumer Price Index at 8.3%, and the Fed’s preferred Core PCE at 4.9%, both much above what the Fed would like to see. This combined with historically low unemployment (3.7%), provides little reason for the Fed to slow the pace of interest rate hikes or reduce their rate of asset sales. This contractionary monetary policy is the main reason for the market’s woes in 2022.
We saw a relief rally through the first half of the quarter and then a reversal that ended with markets hitting new lows by the end of September. All major asset classes were losers with international stocks, gold, REITs, and longer-dated bonds leading the drop. The one bright spot with family’s balance sheets is their home. Housing prices are up 16% and those who got mortgages prior to 2022 are enjoying a very attractive interest rate.
The following bullet points were some of the highlights from the quarter:
- US Stocks rallied 14.6% through the first 47 days of the quarter and then fell 16% over the final 44 days to finish the quarter 4.4% in the red.
- The Federal Reserve hiked interest rates twice, each by 0.75%. That brought the Fed Funds Rate from 1.625% to 3.125%. The yield on the U.S. 2-year closed the quarter at 4.22%, up almost 4% from the 0.28% we saw a year ago.
- Crude oil began the quarter at $107.76/barrel and fell 26% to close the quarter at $79.91.
- The U.S Dollar rose to its strongest level in 20 years, passing parity with the Euro ($1 now buys €1.02).
- The aggregate bond market is down 14.4% on the year. The next worst year in history is 1994 at -2.9%. Prior to this year, a statistician would have told you a 14.4% drop is less than a 1 in 1,000 event.
- 30-year fixed mortgage rates are up in the last 12 months from 3% to 6.7%.
- Homeowner equity increased 20% over the last 12 months.
We expect the two biggest factors affecting the market going forward to be inflation and the war in Ukraine. The longer both endure the worse for the markets. Much attention will continue to be given to inflation readings and the two meetings of the Federal Reserve (Nov 2nd & Dec 14th). Additionally, corporate earnings will be closely watched to see if companies can continue to deliver strong results. If earnings came in at or above expectations, we could see some disconnect between equities and bonds with stocks rallying and bonds selling off. We don’t see the mid-terms as being a large driver of the markets. The expectation is for Republicans to gain control of the House. The Senate is more of a toss-up but inconsequential if the House goes Red. At this point, its impact is probably priced into the market.
It's painful to stomach the drop in portfolio values, but there is a big silver lining. With the jump in yields, we are increasing our long-term expected returns from both equities and fixed income. We now expect 9.25% from stocks going forward and 4.5% from bonds. These are huge improvements over where things stood at the start of the year (7.5% and 1.75% respectively).
We remain committed to our long-term investment approach of broad exposure to a portfolio of stocks and bonds appropriate for your specific financial situation. These are rocky waters, but we’ve seen worse. Whether it’s 2008, the dot-com bubble, or the 73-74 crash, we’ve learned that those who stay invested are handsomely rewarded, it’s just a matter of time.