Higher Inflation, Fed Rate Hikes and Geopolitical Risks Weigh on Stocks and Bonds in the 3rd Quarter
Stocks started third quarter with a solid rebound driven by resilient corporate earnings, signs of a possible peak in inflation, and hints from the Federal Reserve that the end of the rate hiking cycle may come sooner than markets initially expected.
Starting with earnings, corporate results for the second quarter were much better than feared. Despite high inflation and lingering supply chain issues, the majority earnings beat estimates, and that solid performance by corporate America showed investors that, despite numerous macroeconomic challenges, earnings were holding up better than expected. On inflation, several reports showed price declines in June and offered hope that inflation pressures were peaking. Finally, in late July the Fed raised interest rates by another 75 basis points, but at the press conference Fed Chair Powell stated that, at some point in the future, it’d be necessary for the Fed to slow the pace of interest rate increases. Investors interpreted that as a signal that the end of the rate hike cycle may be closer than previously thought. That and a possible peak in inflation fueled a 9.2% gain in the S&P 500 in July, its best monthly return since November 2020.
But throughout August and September that optimism was eroded by sticky inflation data and a more hawkish-than-expected Federal Reserve. Fourth quarter markets remain in search of concrete positive catalysts that signal declining inflation pressures and a less-aggressive Federal Reserve.
Third Quarter Performance Review
Switching to fixed-income markets, most bond indices posted negative returns for the third straight quarter. Stubbornly elevated inflation, continued Fed rate hikes and a late-quarter selloff in global sovereign bonds (driven by the ill-conceived fiscal spending package from the United Kingdom) saw most bond classes end the third quarter lower, extending the year-to-date declines.
Looking deeper into bond markets, as has been the case all year, shorter-term Treasury Bills outperformed longer-duration Treasury Notes and Bonds as the threat of greater than previously expected Fed rate hikes and still-high inflation weighed on fixed income products with longer durations. For the second straight quarter, short-term Treasury Bills finished with a slightly positive return.
Corporate bonds relatively outperformed longer-duration government bonds in the third quarter thanks mostly to still-solid U.S. economic data. Higher yielding, lower quality corporate debt declined less than investment grade corporate bonds as resilient corporate earnings kept default risks generally low.
Fourth Quarter Market Outlook
Markets and the economy are still facing numerous challenges from still-high inflation, ongoing Fed rate hikes, and geopolitical instability. But while the outlook for risk assets remains challenged, that reality must be considered in the context of a market that has declined substantially and, presumably, already priced in a lot of “bad news.” Valuations on many quality companies are approaching pre-pandemic levels, while the S&P 500 more broadly is trading at a valuation that has, historically speaking, been attractive over the longer term.
Additionally, multiple sentiment indicators have hit or are approaching levels that historically have represented extreme pessimism and bearishness, and they are largely ignoring the reality that there has been some improvement in the macroeconomic outlook over the past several months.
First, inflation has likely peaked. Multiple inflation indicators are showing a peak and decline in price pressures, and while the Consumer Price Index remains far above the Fed’s target of 2%, any swift deceleration in inflation would likely be a material positive catalyst for both stocks and bonds.
Second, the less-aggressive Fed pivot will still occur, perhaps as early as the fourth quarter. According to the Fed’s estimates, interest rate increases will begin to slow in the coming months, and the last rate hike for this cycle could occur in March 2023 or sooner. If that turns out to be the case, and the Fed signals to markets that this rate hike cycle is approaching its end, that will likely be a materially positive catalyst for both stocks and bonds, and that’s evidenced by the July and August rallies that were driven by hopes of a less-aggressive Fed.
Finally, amidst a difficult macroeconomic backdrop, the U.S. economy and corporate America have proven impressively resilient. Most measures of U.S. economic growth remain in solid shape, while U.S. corporate earnings estimates have stayed largely elevated, and the widespread earnings declines that were feared back in early 2022 simply have not materialized.
Bottom line, the outlook for markets and the economy remains challenged, but investors have priced in a lot of “bad” news already, with valuations now at levels that are historically attractive. Additionally, sentiment is as pessimistic as it was during the depths of the financial crisis, and if inflation suddenly decelerates quickly, the Fed signals a clear end to rate hikes, or there’s positive geopolitical news, the potential is there for a powerful rally in both stocks and bonds.
This is a difficult market and a complicated moment for the world, but history is clear: Positive surprises can and have occurred even in difficult times such as this, and through periods of similar turmoil, markets eventually recouped the losses and moved to meaningful new highs. There is no reason to think this time will be any different.
At Brixton Capital Wealth Advisors, we understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this challenging investment environment.
Successful investing is a marathon, not a sprint, and even extended bouts of volatility like we’ve experienced so far this year are unlikely to alter a diversified approach set up to meet your long-term investment goals.
Therefore, it’s critical to stay invested, remain patient, and stick to the plan, as we’ve worked with you to establish a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline.
Rest assured that we remain dedicated to helping you navigate this market environment. Please do not hesitate to contact us with any questions, or comments, or to schedule a portfolio review.