Odds of a deliberate Fed-induced recession increased materially in 3Q, dragging markets lower. Should a recession occur in ’23 we think strong labor markets and consumer balance sheets can provide economic support and limit the magnitude of slowdown. Near-term markets are likely to remain volatile as the Fed aggressively combats inflation, and we suggest investors control risk exposure and focus on alternatives such as real assets.
Blunt commentary from the Fed resets market expectations
- Inflation is stabilizing but hasn’t “broken” yet.
- The Fed cemented its hawkish policy stance in 3Q, putting to rest any speculation the tightening cycle would end soon.
- Diversification in portfolios continued to largely fail in 3Q with most major asset classes now down double-digits for 2022.
- Interest rates and yields soared in 3Q with the US Treasury 2-year ending the quarter over 4% for the first time since 2007.
- Diverging central banks, commodity prices, global growth outlooks, and the ongoing conflict in Ukraine all contributed to the USD surging to its highest level in over two decades.
- We suggest investors limit outsized risk exposures, strategically add to equities, and focus on alternatives such as real assets.
Key Markets Performance in 3Q22
To say that financial markets were unsettled and volatile during the third quarter is an understatement. In a continuation of the year-to-date trend, the stock market’s trend changed multiple times intra-quarter as investors reacted to data (e.g., the Fed and inflation) and repositioned portfolios.
After decisively hawkish commentary from the Fed at Jackson Hole and additional 75bp rate hikes markets got the message. Capital markets responded to the aggressive policy stance with a rapid retreat. The S&P 500, which at one point was up nearly 15% intra-quarter, finished the third quarter down 4.9%, while the 2-year Treasury yield finished the quarter at 4.2%, a level not seen since 2007.
Major Market Performance in 3Q22
Our core assumptions from earlier this year, that the strength of the US economy could withstand a hawkish Fed and tightening cycle, have adjusted. While we continue to maintain our stance that strong labor markets, good consumer balance sheets, and solid corporate margins support a growing US economy, we cannot overlook the Fed’s deliberate intention to compress growth at all costs (See “Looking Ahead” for more discussion). As such, the odds of a Fed-induced recession in 2023 have increased.
Any doubt in the Fed’s constitution to fight inflation was eliminated in 3Q. For investors, this means preparing for a prolonged higher rate environment and elevated volatility. We suggest keeping cash on the sidelines to opportunistically buy equities, avoiding outsized credit or duration exposure, and focusing on alternatives such as real assets which have meaningful collateral and downside mitigations.
Fed Dot Plot
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A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.