Quarterly Update

Market Update: Higher for Longer

Investors looking for relief from this year’s volatility found nothing but more misery in Q3 as markets continue to validate our higher for longer outlook. What began with a short-lived rally in equity prices and Treasury yields ended with the S&P 500 dropping to a new year-to-date low and Treasury yields surging to their highest levels in more than a decade. Declines in markets outside the US were worse still amid heightened geopolitical turmoil, aggressive policy tightening and the dollar’s steep ascent. Even commodity prices, a rare bright spot earlier in the year, fell due to flagging global demand.

With investors of all stripes finding little place to hide, 2022 continues to be one of the most challenging years in memory. It is highly unusual to see both stocks and bonds decline in tandem so dramatically. In fact, the traditional 60/40 portfolio mix of stocks and bonds, designed to offer a degree of downside protection in turbulent markets, has now posted its worst first three quarters of performance in more than 50 years. Yet, as painful as this current experience has been, history shows there is cause for optimism over the longer term. Investors will first, though, likely need to exercise some more patience.

As we look across the waning months of 2022 and into 2023, many factors that have crushed markets this year – persistently strong inflation, slowing growth and hawkish central banks – are likely to continue, at least in the near term. From our perch, the two biggest risks are that even more forceful tightening by the Fed might be required to dampen demand and rein in inflationary pressures, and that higher for longer interest rates cause problems in the financial system, which then seep into the real economy. As the recent breakdown of the UK Gilt market illustrates, policymakers face an increasingly difficult trade-off between combating inflation, supporting economic growth and maintaining financial stability.

There are many other things that can go wrong, Russia’s war with Ukraine is fueling a continuing crisis in global energy and food markets, with Europe likely already slipping into recession. Meanwhile, President Xi’s consolidation of power in China signals a coming period of growing conflict with the West, as well as the continuation of its zero-COVID policy and increasing governmental control over the private sector that has already caused serious damage to the world’s second-biggest economy. We are in a risky environment, and though the US may be insulated to some degree from external crisis and shocks, as we’ve been repeatedly reminded over the past two years, what happens halfway around the world can have significant reverberations here at home.

While the strong start to Q4 has been a welcome reprieve for investors, we are happy with the de-risking steps we’ve made in client portfolios and continue to maintain our cautious approach to asset allocation positioning. For now, markets don’t seem to be fully factoring in the extent of a potential slowdown ahead, nor the risks that geopolitical developments pose on inflation and the stress from policy tightening on the global financial system. Relief rallies are a common feature of bear markets, and as a more challenging outlook for the economy and corporate earnings is discounted by markets, we believe there is further scope for stocks to grind lower, even if government bond yields do not rise any further.

Still, not all is doom and gloom. Though US economic momentum is slowing, underlying fundamentals remain strong, which should keep any potential recession relatively mild by historical standards. While we do see some similarities today to the tech bubble burst in 2000 and the inflation-induced bear markets of the 1970s, the arguments against a harsher economic downturn and a more serious structural bear market development are strong. Relative to the eve of prior recessions, US banks remain well-capitalized, consumer and corporate balance sheets are healthy, and the labor market is tight, all of which should help mitigate against shock factors with negative feedback loops that can turn a shallow recession into something deeper.

If we are right about all this, then we are likely closer now to the end of the painful reset in asset prices than we are to the beginning. The current bear market is now nine months old, more than half as long as the cyclical post-war average for bear markets. There’s likely more volatility to come, and it’s not certain that we’ve seen the low for financial markets, but we think it is increasingly probable that the bruising start to 2022 has set the market up for somewhat better long-term performance. In the meanwhile, we think our focus on holding high quality and income producing US stocks and bond can provide client portfolios with relative stability until ongoing market turbulence subsides.

Since 1927, there have been six instances where the 60/40 portfolio mix has declined by 10% or more after nine months. While returns on average were more negative six months later, cumulative returns after one and three years were 9.8% and 25% respectively. Bonds may continue to struggle with rising rates in the months ahead, but as investor concerns shift to slowing growth, there is scope for yields to fall. Likewise, stocks may face additional downside as earnings expectations are revised down, but significant repricing has already occurred. Though it can be difficult, we think this is a good reminder for investors that it is important to focus not on where returns have been, but on where they could go in the quarters and years ahead.