The third quarter of 2022 is in the books concluding the worst three-quarter decline for the stock market since the financial crisis. September was another rough month as the Fed continued to double down on inflation after yet another high price report from August.

We also had stronger than anticipated consumer confidence and jobs reports. Good news is bad news at this point. Stocks fell with the S&P 500 now down almost 25% and the NASDAQ Composite collapsing over 30% on the year. Bond yields soared again with the 2-year Treasury yield, a measure for Fed Funds rate expectations, rising to over 4.3% before settling back down to under 4.1%. The 10-year Treasury yield briefly touched 4% but has since fallen to the 3.6% to 3.7% range further inverting the yield curve.

Some signs of a slowdown are emerging especially in supply chain manufacturing and production indexes. OPEC+ countries appear to be discussing a drastic cut in production to support oil prices as falling global demand has had a swift and strong effect in reducing them recently. Ongoing US dollar strength will continue to hit multinational companies’ bottom lines, potentially helping the lower inflation cause.

It has now come down to how much inflation we can and will accept to avoid more economic pain. As far as stocks have fallen, we are still only at around late 2020 price levels, putting into perspective just how large the sugar high from markets was over the last two years. More volatility should continue as market participants look for a bottom in stock and bond markets.

Some good news might finally be found in the bond market after the first global bond bear market in 70 years has taken hold, according to Deutsche Bank. Bond yields are starting to look attractive across the board with even the highest quality companies issuing debt with over 5% yields and short-term Treasury yields at over 4%. Municipal bonds are offering steep discounts with tax equivalent yields of over 5%. Preferred stocks, with their bond like characteristics are another attractive income option yielding 6-7%.

The silver lining to bond prices falling and tighter central bank policy is less risk and higher income yields for savers once the damage is done. In other words, receiving real income from fixed income. The question is - when would the sell off hitting bond portfolios start to stabilize given the Fed’s ongoing commitment to raising rates?

The answer might be sooner than most people expect as yields in longer dated treasury maturities have been slightly falling even with rising short-term rates. Bonds have already been beat up in a big way this year with the overall market down over 15% and longer dated US Treasury bonds down close to a whopping 30%, losing even more than some of the riskiest global debt.

From a textbook standpoint, longer dated investment grade and government bonds are the place to overweight your portfolio to weather a recession and we believe this is starting to take shape. By even the Fed’s own projections, the rate hiking cycle should be wrapping up in the next 6 months. We have now reflected this in our bond allocations.

Currencies in Crisis?

Outside the United States, it has been an especially difficult year for developed and emerging market economies for reasons that are manifold including rapid inflation, an energy crisis, the war in Ukraine, and a tepid labor recovery from the pandemic. Is it finally time to overweight international equities relative to domestic stocks? Not quite. The new headwind appears to be the intractable US dollar and collapses in even the largest safe haven currencies. The greenback has only strengthened as interest rates continue to rise, attracting foreign investors and increasing demand for dollars. Domestic investors can lose more than just the negative return priced in the local currency. The loss becomes magnified when the currency drastically depreciates against the dollar once the investment is repatriated if it is not hedged.

Despite ongoing rising prices and a reversal in attitude towards globalization, US consumers continue to import goods. A dominant dollar should only serve to help this cause as foreign goods become cheaper. Overall, this would help ease inflation domestically, but with the side effect that it could really start to damage an already fragile global economy wrought with geopolitical risks. Dollar priced goods and services are becoming more expensive, and this could hurt US exporters, further slowing domestic growth. As much as the US imports, it is still the world’s second largest exporter after China.

The irony is that for many years after the 2008 financial crisis, there was a “race to the bottom” so to speak for central banks to lower interest rates, weakening currencies and strengthening exports. Now, central banks are feeling pressure to raise rates quicker, not just to tame inflation, but to keep up in maintaining currency value. This raises the risk that rates rise too fast, exacerbating already receding global economic growth. Coordinated hikes and sharply rising bond yields are even starting to send troubling ripple effects to pension funds overseas and major banks such as Credit Suisse.

Keeping the pound “sound”…

In a very rare and well publicized move, the Bank of England had to step in to support the pound sterling, as significant borrowing plans that were put in place to offset ambitious tax reductions lowered faith in the country’s ability to pay its debts.

The situation became more dire by the day as the British government moved in one direction to stimulate the economy via lower taxes and the central bank moved in the opposite direction to head off inflation through aggressively higher interest rates. After substantial pushback from international investors, the UK government pulled a U turn and reversed the plan to cut taxes for the highest earners and the pound rallied against the dollar. Elsewhere, the Bank of Japan spent record amounts on intervention to support the Yen.

The recent market activity shows that we are now in the thick of global stagflation – lower growth and out of control inflation. The US Treasury is responsible for managing the domestic currency in relation to other global currencies. A US dollar this strong, appreciating at a break-neck pace even against traditional safe havens such as the Japanese yen, euro, or the British pound sterling, might entice the Treasury to intervene.

Yet, with the Fed’s singular focus to rein in inflation, that would be counterproductive. International markets have been discounted to US markets for some time now but remain that way for many reasons. Any exposure outside of the US should be carefully constructed and ideally actively watched or managed. We proceed with caution.

Looking forward, we will keep an eye on September’s inflation and jobs reports and the developments close to the mid-term elections. We will look for earnings forecast downgrades as well. October is historically a difficult month for stocks, but the good news is that every 12-month period following mid-term elections have been positive dating back to 1942. We will see if this continues to hold true. In the meantime, we remain very heavy in quality, high dividend, and defensive sector allocations and will look to take advantage of higher yields in fixed income. We will be on guard for any breakdown in financial conditions and contagion globally.

It has now been almost a full year since I began writing these market updates on behalf of KLR Wealth. I wrote back then that it was a real “treat” to be working with such an excellent team. After getting to meet and work with our wonderful clients while overseeing our investment program, it still is an absolute pleasure. Despite navigating all of the unexpected market and global events, we are thrilled to help guide you and your investments through these volatile times. Please never hesitate to reach out and we look forward to continuing that guidance no matter what the future holds. The fall colors and the market dynamics are changing, but we stay steady in our service to you!

SAVE THE DATE! KLR Wealth Webinar: Post Election Market Update- November 10, 2022.

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