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Monthly Market Update- September 2022

September 01, 2022

The kids are back to school and the bears are back in town. After a month-long rally, markets stumbled to mid-July price levels. Will the seesaw continue in September?

It went boom, then bust for equities in August, with the worst cross-asset class selloff since 1981. There was nowhere to hide – even commodity prices fell. US Treasuries dropped 2.2% and the S&P 500 index lost 4.2%. International stocks fared about the same, with Europe falling more than Asian equities. Bond yields jumped across the curve, especially in short term maturities, reflecting hawkish monetary policy. The two-year treasury yield moved above 3% early in the month, climbing to over 3.50% at one point, touching its highest level since 2007. The treasury yield curve is still heavily inverted.

In looking at sector performance, defensive and inflation resistant companies did best, with industrials, energy, financials, materials, and staples leading the way in positive territory. Technology stocks gave up the most, losing over 6 percent for the month, with REITs and consumer discretionary not far behind.

What stopped the bear market rally?

The financial world’s attention turned west as Federal Reserve President Jerome Powell again took center stage in Jackson Hole, Wyoming for the annual Economic Policy Symposium last week. It only took an 8-minute speech to send the markets south, sharply driving down US stocks over subsequent market sessions. The “Powell policy pivot pushback” (say that ten times fast) was clearly communicated as the Fed Chairman spoke of the ongoing interest rate hikes probably causing "some pain" for households and businesses. The commitment to the price stability side of the bank’s dual mandate is evident and possibly a move to re-establish credibility. It was apparent that the current policy prescription was not, in fact, pivoting for the foreseeable future, removing hope from investors looking for dovish signs. Many Fed governors supported this.

We had been dubious of the tech-driven bear market rally and a potential return to dovish Fed policy, given peak inflation. Nothing Chairman Powell stated in his speech surprised us or many other investment colleagues that we have spoken with. Yet, the markets seemed to sober to the fact that inflation has been entrenched, supply chain issues remain, and geopolitical risks are as strong as ever.

Just because inflation has dipped slightly and there is weakness in economic data, it does not mean that the Fed can simply change course right away. Prices are still way too high for wages to keep up with. There are also secular trends that will continue to create inflationary pressure, such as the move to re-shore companies and the urgent race for eco-friendly commodities. Labor demographics and the lack of available workers in general is another issue.

The Fed is doubling down on raising rates and removing liquidity, despite stagnating GDP growth.

At first glance, US and European central bank policy can be confusing in tightening financial conditions despite where we appear in the business cycle (negative growth, weaker real estate market, etc.). Central banks can affect demand much more so than supply issues, which has been the main cause of price increases. Inflation from supply side shocks tend to be countercyclical when growth stagnates (hence the term stagflation). This situation is not as common and central bank policy mistakes can have a drastic impact with the risk greatest at the top of the cycle (where we are). Unfortunately, the Fed does not have much of a choice with interest rates still too low and the urgent need to tighten conditions to rein in unacceptable levels of inflation.

Central banks may overestimate the economy’s ability to absorb restrictive monetary policy via higher interest rates and quantitative tightening. This can be very problematic, hitting the economy with a double whammy: raising the cost of borrowing at a time when the economy is contracting and prices remain high. In such situations, this may trigger an even bigger slowdown that it cannot immediately counteract. Switching to expansionary monetary policy when needed works much slower. There is a well-known saying among seasoned investors - “expansionary policy is like “pushing” on a string, whereas restrictive policy is like “pulling” on a string.” There must always be a balancing act between managing GDP growth and inflation. It is quite the tight rope that the Fed is walking on.

There is some good news to highlight regarding recent data.

A batch of companies reported retail earnings that painted the picture of a somewhat resilient consumer, according to FactSet. Regional manufacturing surveys are still showing signs that inflation is slowing down a bit. There was also progress made on long awaited inventory levels coming back which could ease price pressures.

Internationally, China’s manufacturing and housing slowdown, along with Europe’s energy and inflation crisis is a headwind in the short term. Larger Chinese tech stocks did rally on news of a deal between the US and China regarding audit transparency. Overall, International markets are very cheap, but the economic pain is not over yet and we remain underweight Ex-US strategies.

The spillover effects from the Russia-Ukraine war are ill-timed and only making things more unpredictable for global markets. Japanese stocks could be a bright spot, but the country faces many of the same challenges in demographics and Yen weakness. The US dollar strength is unmatched, with the reserve currency notching a third straight month in gains against most currencies.

Despite the abrupt bearishness, the drop in market prices makes sense given the economic backdrop.

The current fall in market prices makes more sense than the recent unjustified rally. It is a healthy development in that markets are not floating away from economic reality. The silver lining with this volatility is that we were prepared and continue to expect more into 2023. It should bring opportunities as it typically does. Our defensive and quality factor allocations remain within our portfolios, and we invest with strategies that are grounded in fundamental research and analysis. At this point in the cycle, fundamentals start to matter even more. We will keep our long-term strategic approach in place as the weather (and hopefully inflation!) cools down.

Enjoy the rest of your summer!

Questions? Comments? Contact us.

Investment Advisory Services offered Through KLR Investment Advisors LLC
951 North Main St, Providence, RI 02904

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