Quarterly Commentary

3Q 2022

Q3 review – fighting inflation

The quarter started with investors thinking the US was near or past peak inflation, and stocks gained 15% from their June lows. Hopes that the Federal Reserve would be able to fight inflation without risking job losses and/or a recession played a role in the rally - no doubt fear of missing out did too. By mid-August stocks had more than halved their year-to-date losses. Those hopes were dashed as Fed leaders reiterated their determination to minimize the threat of persistent inflation. The rally became a rout in September – stocks finished down 4% in Q3 at their lowest level this year.

At this point stocks and bonds are each heading toward one of their worst years ever. Usually, gains in one offset losses in the other - clearly this is not a normal year, and this is not a typical sell-off.

The Fed began tightening in March when it started to raise short-term interest rates and halted the asset purchases that had been supporting financial markets since the onset of the pandemic. Perhaps regretting they didn’t move sooner; the Fed’s governors have aggressively pushed the benchmark fed funds rate from zero to 3%. The Fed also initiated the process of unwinding its bond portfolio by letting existing holdings mature and not replacing them, which reduces money supply.

The Fed doesn’t directly control the prices of goods and services – the complicated forces of supply and demand do – but its tools are meant to stimulate or, in this case, to suppress business and consumer spending. Higher borrowing costs dampen investment and spending and are already pouring ice water on the housing market. The effective interest rate for a conventional 30-year mortgage recently touched 7%. Fed minutes indicate an intention to raise short rates to 4.25% by year-end and acknowledge that unemployment may rise to 4.4% from today’s 3.5%.

These measures will eventually have the desired effect – the question is, “at what cost?” If the Fed gets help quelling inflation from improving supply – of just about everything – labor, housing (residential or rental), groceries, vehicles, appliances, and so on, the transition will be easier. The causes of today’s supply shortfalls are diverse – the war in Europe, China’s rolling Covid shutdowns, crops destroyed by extreme weather – and while some constraints are easing, others have no end in sight.

Waiting for the pivot

Disheartened by the stock market’s relentless decline, investors desperately want to know when the Fed might pause. (What most really want to know is when it will be okay to buy!) Though we can’t identify timing or assess probabilities, we see three scenarios as most likely: 

  • Inflation data starts to soften materially, the Fed indicates it will slow or pause rate hikes, and we get the hoped for “soft landing,” which may still involve a shallow recession.
  • Something breaks. Higher rates and/or less liquidity cause sufficient market turmoil that the Fed is forced to back off (i.e., subprime loans blew up as the Fed tightened in 2008).
  • The Fed follows through on its intentions, and inflation returns to a 2 to 3% “comfort zone,” but only after forcing a significant recession in the US (and most of the developed world).

Each of these developments would likely lead to different timelines for a recovery of stocks and bonds. The first scenario could ignite a robust relief rally with staying power unless inflation reaccelerates. The others may result in more volatility before markets find their footing. Though a background factor this time around, getting past US mid-term elections may reduce some uncertainty. History is supportive - stocks have moved higher in the twelve months following every mid-term election since 1942 – posting an average return of 15% (WSJ 10/3/22).

What to do now?

Stock markets in the US and Europe now price in a recession, so whether we get one or not is likely less important than how inflation evolves and accordingly, how long the Fed and other central banks keep tightening monetary policy. The range of outcomes remains wide, and we continue to focus on investing for many different scenarios. As we have seen many times, the importance of making it to the other side of the uncertainty and not bailing out in the middle of the storm cannot be overstated.

Markets are always looking for what is coming next. Next year we hope to be worrying about what comes after inflation is tamed, while we recognize that higher rates could remain in place for quite some time. This requires adjustments, but it doesn’t change our process. Higher rates increase both the cost of capital and the discount rate we use in financial models, which reduces our estimates of company valuations to varying degrees. As difficult as these periods are, they also present opportunities. Durable companies with stocks trading at levels that already reflect unpleasant future scenarios may be attractive for long-term investors.

As always, patience, perspective and humility are required as we navigate this challenging year. We are not betting on better markets over the rest of 2022, nor are we ruling them out.