Are We There Yet?
Stubbornly high inflation and a surprising projection for a peak Fed Funds interest rate in the range of 4.5%-4.6% by the Fed caused interest rates to surge higher which roiled global financial markets[1]. In addition to higher-than-expected near term interest rates, the Fed’s projection for 4.6% at the end of 2023 indicated that interest rates may remain higher for longer and this notion rippled through the yield curve causing the bond market to experience its worst month in 20 years.
As the sell-off gained steam, the market narrative shifted to a fear that the Fed’s determination to stomp out inflation increased the odds of recession. Recessions mean that the corporate earnings outlook is likely to be materially worse and, therefore, stock valuations decline. This sentiment weighed heavily on stocks in September.
The S&P 500 ended the month down -23.9% year-to-date and fixed income yields increased to levels we have not seen in over a decade. The natural question is when will those markets reach the bottom?
Market Update
Global equity markets sold off significantly in September. There were few places to hide as the developed world shares the struggle against inflation, rising interest rates and declining economic conditions. The S&P 500 fell -9.2% as recession fears permeated the market. The forward price-to-earnings (“PE”) ratio fell to 15x. In our analysis of prior market pullbacks, the S&P 500 tends to bottom at 14x, which means it is getting closer to a bottom but may have more to fall. It is important to note that this theory is merely an observation and not an absolute truth.
The fixed income market experienced an extraordinary month. The Bloomberg Aggregate Bond index, a standard benchmark for fixed income, fell -4.3% in September to leaving it down -14.6% for the year. The dramatic decline in what are normally considered safer investments is primarily due to high levels of sensitivity to higher interest rates. With the underlying base rates surging, such as the 10 Year U.S. Treasury bond rising from 3.19% to 3.83%, lending products from bonds to bank loans to mortgages experienced a dramatic repricing. Widening spreads also contributed to the sell-off as higher credit and liquidity risk were absorbed to account for potentially higher recession risks.
Even commodities did not escape the sell-off. The Bloomberg Commodity Index dropped -8.3% during September on fears of demand destruction typically experienced during recessions. The index finished the month still up on the year (+12.4%). Nearly all commodities suffered. Natural gas, which has been a big winner this year, finished September down -25.9% but remains up 81.4% for the year.
Each asset class had a dramatic September. Simultaneous sell-offs like this are generally associated with periods of significant market stress.
The Current Rate Hike Cycle is Different
The root cause of this dramatic interest rate volatility is the Fed’s policy actions to tackle record inflation. As we pointed out last month, the Fed’s hawkish tone that emerged in Chairman Powell’s speech in Jackson Hole, was meant to prevent businesses and consumers from increasing their inflation expectations. The reason why this is so important is that higher inflation expectations can lead to spending and investment behavior that is not conducive to long term economic growth. The University of Michigan’s consumer survey on inflation expectations (chart below) seems to indicate that Powell is succeeding at driving those expectations back down to pre-Pandemic historical norms[2]. This trend bears close monitoring.
To achieve these declining inflation expectations, however, has required the fastest, biggest and most abrupt interest rate hikes in the last three decades (see table below). Using the Fed Futures curve to assume this rate hike cycle will peak at 4.40%, this cycle will have experienced the largest increase from start to finish in one of the shortest timeframes and in the chunkiest individual moves (i.e., one 50bps raise and three 75 bps raises). The dramatic nature of this rate hike cycle is quite disruptive to risk assets and has led to significant interest rate volatility and contributed to overall poor stock and bond performance.
Monthly Market Review & Outlook
September 2022
It is entirely possible that the Fed will not stop at 4.5-4.6% in which the market may have to readjust further. For the Fed to stop, they will need to see a solid trend downward in inflation and it is still too soon to say.
Outlook
Have the markets reached a bottom? We remain defensively positioned as the conditions necessary for taking additional risk are not yet in place. How far away the bottom is depends on the asset class. With the recent surge in bond yields, high quality, short duration bonds offer attractive yields with limited risk. If disinflation takes hold, we believe that interest rate volatility may decline, which may create an opportunity to add duration to the bond portfolio. Investment grade bonds and mortgage-backed securities may provide attractive yields with potential upside from spread compression. This may occur by year end.
To materially increase equity exposure, however, we need corporate earnings estimates to stabilize. Nearly all of the stock market’s decline this year is due to an expectation that corporate earnings will be lower, although, we have yet to see materially downward revisions to these earnings. Until such time as the corporate earnings outlook has been right-sized, the stock market faces headwinds. This process may take a couple of quarters and the stock market could fall further before finding a bottom. We conducted an analysis of prior recessions and determined that the S&P 500 tends to bottom approximately 7 months before the economic bottom. This means that the stock market tends to turn up well ahead of the economy. This does not mean, however, that all stocks are off-limits today. Stocks with defensible earnings and cheap valuations can materially outperform even in down markets.
Conclusion
These are unusual times indeed. Persistently high inflation has created higher interest rates that raises the chances of recession and, therefore, lower corporate earnings. Until these variables stabilize, it is difficult to call a bottom. The current environment continues to require a defensive posture. Nevertheless, there is no precise recipe or calculation to determine precisely when the conditions cited above will emerge. So, we wait patiently for opportunities to emerge.
Disclosures
LIM is a Registered Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with a superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
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Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise and investors may get back less than they invested.
Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise.
Investment in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
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Data Sources: BlackDiamond, Bloomberg, Lear Investment Management and various other sources as cited herein.
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to it market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
U.S. Treasury securities are guaranteed as to the timely payment of principal and interest if held to maturity. Investment options are neither issued nor guaranteed by the U.S. government.
The Bloomberg Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Bloomberg U.S. Investment Grade Corporate Bond Index covers U.S. dollar denominated, investment-grade, fixed ratee or step up, taxable securities sold by industrial, utility and financial issuers. It includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity and quality requirements. Securities included in the index must have at lease 1 year until final maturity and be rated investment-grade (Baa3/BBB-/BBB+) or better using the middle rating of Moody’s, S&P, and Fitch.
The Bloomberg US High Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. A small number of unrated bonds are included in the index. The index excludes emerging markets debt.
Bloomberg Commodity Index is comprised of futures contracts and is designed to be a highly liquid and diversified benchmark for commodity as an asset class.