Monthly Market Update- November 2022November 03, 2022
The midterm elections are here with higher interest rates and a global recession looming. How much economic pain will we have to endure before inflation is under control?
October was a strong month for stocks overall, especially in value and small cap stocks, despite much softer earnings and yet another higher-than-expected inflation report from September. The S&P 500 index rose 8%, the NASDAQ was up almost 4%, and the Russell 2000 was up almost 11%. We did have a bear market rally for much of the month, until tech firms like Alphabet, Amazon, Texas Instruments, Meta, and Microsoft reported much weaker sales and earnings. Mega Cap tech stocks sank on the news. The top performing sectors for October were energy (+24.84%), industrials (+13.86%), financials (+11.80%), and healthcare (+9.59%), all sectors we have been overweight within our equity allocation.
Big Tech’s reign over the markets seems to be ending
It was a tough month for tech and growth stocks, continuing a very poor performing year. The rest of the market picked up though on hopes of a soft landing and a potential peak in interest rates. The divide in performance of the tech focused NASDAQ and the rest of the broad market has not been this strong since the dot com bubble. Elon Musk’s finalized takeover of Twitter underscores the strange times in communication services, a struggling subsector of the tech industry. Increased breadth in the markets is good news given the technology sector’s broad market index weighting and slowdown.
Still, earnings overall have not looked good and as discussed in last month’s update, we should see the continuation of a stronger dollar taking a big bite out of corporate profits. Now we have the evidence. The Financial Times estimates that the dollar’s strength has wiped out about $10 billion from earnings for US firms in the third quarter. The Fed’s tighter monetary policy is starting to manifest within the real economy, finally hitting the largest companies’ bottom lines. Our overweight exposure to value, dividend focused, and small cap stocks has benefited our portfolios when compared to the broad market indexes.
Coming recession in 2023?
GDP did turn positive for the third quarter after two quarters of negative growth in 2022, but much of this was due to government spending and energy exports. Most economists expect this to be the last positive quarter for a while. Spending is slowing, inventory is building up, and another 75-basis point rate hike is now confirmed.
Fed Chairman Jerome Powell hinted at a potential slowdown in rate hikes to evaluate the “cumulative” tightening effect during the Fed’s early November meeting. The hope of this “pivot” in policy is largely what’s behind the latest bear market surge in prices. The Fed expects the policy rate to be close to 4.5% by year’s end and is committed to more rate hikes until inflation sufficiently falls. The chairman mentioned that the central bank “had a ways to go” before rate hikes were complete which strongly moved markets.
The velocity and speed of interest rate hikes are the fastest since 1980. Why? It is essentially the Fed’s only tool in the fight on inflation. The central bank can only do so much. They have less direct control over the labor participation rate, despite full employment being part of their dual mandate.
How bad are things going to get?
Are we in danger of repeating the most recent prolonged recessions? No, today’s economy differs from the 2008 financial crisis when there was far more leverage and deteriorated credit. Most firms have gorged on cheap financing, locking in debt offerings at much lower rates giving their balance sheets a boost. There is also an enormous amount of cash still on the sidelines. The employment environment is much stronger as well, almost too strong, thus putting upward pressure on inflation costs.
What we do have is a combination of 1970’s style stagflation encompassing supply shocks with slower growth, pandemic of the early 1900s, and 1940s-like geopolitical risk supporting this theme. Different types of risks and threats remain domestically as well. Faith in our election process will be tested and our cohesion (or lack thereof) as a society will be on display during the mid-term elections this month. Outside of the US, despots are consolidating power, preaching disinformation attempting to undermine western democracies at every turn.
Inflation may go lower, but not away
Aside from the obvious consequences, these secular changes that weaken trust in globalization do not support a deflationary (lower prices) thesis. Reshoring of jobs and industries, higher sticky wages, and the ongoing war for global energy dominance and independence are inflationary forces that could be here to stay. Our workforce is not prepared and large enough to support this domestic growth. Republicans will have to work with the Biden administration if they take control of Congress as expected. They may not be as willing with the 2024 election around the corner, and more gridlock is possible.
Housing is another major issue for the new congress to tackle. This is an area where the Fed policies have had an immediate effect as price growth has slowed. Long term mortgage rates are up over 7 percent for the first time in decades. Housing sales and starts are precipitously on the decline. With prices still too high, these rates make owning a home fundamentally unaffordable for most first-time homebuyers. This affects the building side of things as demand drops. Again, probably not a 2008 situation, but a potentially significant slowdown is in order. Lack of supply should keep home prices from plummeting, at least for now.
Bonds are Back
Investors and strategists are coming around to something we have been optimistic about for a while. Stocks may have stolen the show in October, but better opportunities abound in the fixed income markets. Yields are much higher now for even the safest investment grade debt. Short term triple A rated bonds can yield as much as 6%.
The historic drop in bond prices has driven municipal bonds to the highest yields in 15 years. As interest rates top out amid a flight to quality, there is opportunity for price appreciation in intermediate to long investment grade bonds. Some short-term high yield debt and TIPS can be added in for even more yield enhancement but will require caution with falling inflation and any serious deterioration in credit from tighter financial conditions.
Why the optimism that rates may be peaking and the Fed could be done soon? Although not discussed as much, the lack of liquidity in the bond market might give the Fed pause. Conditions have substantially tightened at an historically quick rate. Without checking the temperature of these swift large rate hikes, they could pose major problems for the financial market’s plumbing, especially if we were to move above 5% short term rates.
Despite repeated statements of doubling down on higher interest rates, if enough of the market’s stability “breaks”, the Feds will have to step in and stop the damage. Sufficient slowing to earnings shows that the Fed’s policies are finally working. We are also near the Fed’s terminal neutral policy rate. Mid to long term yields started to come back down towards 4 percent during the month as earnings reports trickled in.
Risks remain outside the US
Despite being relatively cheap as an asset class, international markets are still fraught with risks warranting continued caution when investing ex US. China wants the Yuan to be a currency that competes with the US dollar on the global stage, but their government policies and a lack of trust in the Xi regime will be an ongoing obstacle. Xi Jinping’s tightened grip on China and his lack of regard for international investors make China almost un-investable.
Russia is now being accused of “weaponizing” food after holding European energy markets hostage. Europe is most likely at the beginning of a deep recession. The strong dollar isn’t helping to ease inflation globally for US goods, beckoning other central banks to tighten monetary policy at a faster pace. None of this bodes well for the global growth outlook. Of all the regions in the world, emerging economies in southeast Asia are being brought up as maybe the only area with positive GDP (growth domestic product) growth next year.
On the horizon, we will be watching for the jobs and inflation reports from October and of course mid-term election results.
Tune into our webinar on November 10th to hear the wealth team’s thoughts on the implications of the elections and impact on markets. A Republican controlled congress would most likely limit fiscal spending in a recession and boost domestic energy production. Higher taxes would most likely be on hold for at least two more years. Even more gridlock could occur and that can be good and bad. Markets like certainty, but there needs to be some level of effective government in order to limit fiscal policy mistakes. This is reflected historically in the months that follow the midterm elections. We will explore these topics and more relating to your portfolio and financial wellness throughout our discussion.
We look forward to seeing and hearing from you soon!
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