The third quarter added to the challenges facing markets, and we continue to navigate the markets from a cautious stance. All financial assets are under stress due to tightening liquidity conditions and the increases in interest rates the Fed has made to contain inflation. Daily moves continue to be dramatic in both directions, producing a saw-toothed path. Short-term traders, options traders and quantitative models are dominating daily action. However, we believe that a sound investment process rooted in thorough fundamental analysis will carry the day over the long term. This current environment is a favorable setup for active management to add value, and we continue to adjust portfolios according to the changing opportunity set.
Real-time data on economic activity and inflation appears to be softening with the cooling housing market as a prime example, but there will be a lag before this data works its way into the Consumer Price Index (CPI) and other statistics. This lagged dynamic is not pairing well with a Federal Reserve that has lost patience and severely damaged its reputation by waiting too long to see if inflation would self-correct as “transitory”.
The market herd is seemingly rooting for some bad news to validate that the economy is slowing such that the Fed might be able ease up on its interest rate hikes. This awkward logic twists short-term investors into trading bad news as good news. A potential “Fed pivot” to less aggressive policy would be a good thing for markets and spur a rally, at least in the short term. However, we caution the trader community to be careful what it wishes for, as a Fed softening could be because the economy and earnings are in rough shape, which would make it difficult to sustain a rally in asset prices.
Third quarter earnings season is now getting into full swing. We expect this quarter’s earnings to hold up reasonably well given that the economy was basically solid from July through September. The much larger issue and area of risk will be the updated forward guidance that companies give for the fourth quarter and into 2023. As shown below, the consensus forecast for 2023 S&P 500 earnings has been coming down steadily (red dotted line), with potentially further to go. Consensus forecasts also still show that earnings will grow nearly 8% next year (gray shaded area), but that optimism has been falling.
source: Strategas, 10/17/2022
For the first nine months of the year, financial assets spent a lot of time correcting to lower prices (and lower price-to-earnings ratios) to reflect the tightening interest rate picture as inflation soared. The sobering possibility is that the deterioration in the earnings outlook might not be fully reflected in prices. All is not lost though. Opportunities are around for active management and security selection, particularly for patient long-term investors
Market Outlook and Q3 Summary
Overall Asset Allocation
Our Asset Allocation Committee was active throughout the third quarter. We took advantage of the early summer rally to move to underweight equities at the end of July ahead of the selloff that took hold in the second half of the quarter. We affirmed our underweight stance at our September Asset Allocation Committee meeting. The small remaining commodities position was also sold at the end of July. The cash raised by these moves was added to fixed income at the better yield entry points now available. Our fixed income allocation is now up to market-weight (neutral), with a concentration in high grade and more conservative bonds. We maintain a slight overweight to cash. We continue to evaluate more alternative investment opportunities to expand diversification and sources of return. Currently, many clients have a small “alternatives” position via a call writing fund in US equities that helps generate additional income to offset downside market exposure.
The graph below shows the story of the quarter with the market coming to grips with the harsh realities of hot inflation data and a determined hawkish Federal Reserve. This realization took the S&P 500 lower (dotted line, left axis) while the US 10yr Treasury bond price fell, and its yield rose (solid line, right axis).
Q3 in One Picture
source: Bloomberg, 10/18/2022
In equities, the early summer rally proved short-lived, and the S&P 500 finished down -4.9% for the quarter with individual sectors performing in a range of -12.7% (communications services) to +4.4% (consumer discretionary). International markets were hit hard with the MSCI All Country World Index (ACWI) ex-US down -9.9% on an especially poor quarter for China down -22.4%. Through the end of the quarter, the US (as measured by the S&P 500) was down -23.9% in total return year-to-date, and international equities (as measured by the MSCI ACWI ex-US) were down -26.5%. We remain underweight international relative to the US.
Along with all the other challenges of higher rates, the current earnings season is likely to also see US multinational companies frequently citing the strong US dollar as a serious hit to overseas revenues. Investors enter this earnings season with reduced expectations and the sour market mood has lowered the bar for companies to beat. Therefore, we could see sharp relief rallies for those stocks turning in results and outlooks better than expected.
Bonds were down in the third quarter with most major indexes down 3-5%. The quarter was characterized by a tug-of-war between investors hoping for a “Fed pivot” to a more dovish stance and Fed governors repeatedly reinforcing their aggressive posture with no plans to relent. The performance of US Treasuries (mid-curve -5.5%, long 25+ year maturities -10.6%) as well as mortgaged-backed securities down -5.4% was among the laggards. It is noteworthy that high yield bonds (-0.7%) and leveraged loans (+1.4%) were the top performing fixed income sectors in the third quarter. We value the diversification these positions offer portfolios, but we keep position sizes moderate considering credit spreads could also face disruption in the coming months.
The key aspect of bond allocations from here forward is the attractive starting yields (4+% in Treasuries and 6-11% in corporate bonds) that create a great “head start” on total return for these assets. These yields are markedly improved versus prior years and create a new, more attractive hurdle rate to consider versus other asset classes.
Alternative Asset Classes
The diversified commodity basket ended the quarter down approximately -4.1%. We no longer have dedicated investments in the sector and sold our last holdings across most portfolios at higher levels at the end of July. Currently, our only widely held alternative investment is in a US equity fund that generates additional income via call writing
There are certainly better long-term prospects after the pullback in valuations so far this year, although the near-term outlook remains volatile and challenged by deteriorating economic conditions. Balancing these dynamics, we are tactically underweight risk assets yet remain confident and strategically invested across an array of attractive positions according to client risk profiles.
The collective market is bearishly positioned, and we could certainly see snapback rallies. Those positive scenarios would be very welcomed, but weighing the odds of all outcomes, we believe prudence and patience is still in order. While we remind ourselves that there are always more reasons to worry than reasons to cheer, the odds of negative outcomes currently outweigh the positive paths more than usual, in our view. The world is facing a unique set of challenges. We are in transition after decades of low and falling interest rates. We have a lethal conflict ongoing in Ukraine. We have climate disruption and geopolitical maneuvering threatening energy (and food) markets in unprecedented ways. It will be a particularly trying winter for US, European and other northern hemisphere consumers. The US mid-term elections and related policy-making create additional uncertainty.
There is an investment adage that reminds that short-term volatility is not the same as risk of permanent capital loss. Prices have been volatile this year and are likely to remain so. However, the vast majority, if not the entirety, of the assets we follow are not at any material risk of default, bankruptcy or permanent capital loss. The same cannot be said for many SPACs or certain meme stocks, for example. The dire consequences for some of these speculative and leveraged corners of the market will continue to have ripple effects across the entire market and create big headlines. During these times of noisy news flow, it is important to remember that Cambridge Trust client portfolios are built to withstand interim volatility. As you would expect, we have been pursuing tactical opportunities and adjusting portfolios more frequently this year, but we have not deviated from our core philosophy that high-quality stocks and bonds will be the cream that rises to the top and compound to the best risk-adjusted returns over the long term.
 SPACs = Special Purpose Acquisition Companies, also known as “blank check companies”
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