As has been the trend for much of 2022, equity markets ended the month lower across the board as investors continue to try to price in a more drawn-out period of near-record breaking inflation and corresponding monetary policy decisions out of the Federal Reserve (“the Fed”), both of which we will discuss later in this commentary. Leading the indices lower was the Russell 1000 Growth, which fell by 4.76%, followed closely by the NASDAQ, which lost 4.64% during the month of August. The more value-focused indices faired only slightly better as the S&P 500, the Dow Jones Industrial Average and the Russell 1000 Value saw declines of 4.24%, 4.06% and 3.2%, respectively over the month of August.
August Stonemark Market Commentary
From a sector perspective, only the Energy (+2.18% for the month of August) and the Utilities (+0.07% for them month of August) sectors ended the month in positive territory. Weighing on the broader market were the Information Technology (-6.26% for the month of August), Healthcare (-5.88% for the month of August), Real Estate (-5.71% for the month of August) and the Consumer Discretionary (-4.72% for the month of August) sectors.
Inflation and the Fed
On August 10th we received the Bureau of Labor Statistics’ reading for the July consumer price index (“CPI”) data, which came in at 8.5% on a year-over-year basis and 0% on a month-over-month basis. When the volatile products of food and energy are removed from the equation, CPI ex-Food and Energy came in at 5.9% and 0.3% on a year-over-year and month-over-month basis, respectively. While inflation numbers have come off of their June highs, these readings are still severely elevated above the Fed’s 2% inflation target. As a result of this persistently high inflation, the Fed will undoubtedly be forced to raise interest rates at the remaining four Federal Open Markets Committee (“FOMC”) meetings. Looking at the two graphics below (the first is as of the end of the July and the second is as of the end of August), market participants are now pricing in an additional 50 basis points (“bps”, 100bps = 1%) by the end of the year (yellow bars are the December target ranges).
As a reminder when we look at data out of the CME Group’s FedWatch tool, these probabilities are set by traders who are actively trading futures contracts for where they expect the Fed Funds rate to be at a given point in time and can be quite volatile as certain economic data is released. That being said, barring any extremely surprising economic data that deviates significantly from analysts’ expectations, this tool has been fairly accurate in forecasting upcoming monetary policy decisions out of the FOMC. As a result, the dramatic shift that we are seeing towards the right side of the chart would indicate that market participants are expecting the Fed to be quite a bit more aggressive when it comes to tighter monetary policy as we enter the final quarter of 2022 and into the first half of 2023. While the economic data from the CME Group’s FedWatch tool and the sentiment out of the Fed would suggest that we are in for at least another 150bps worth of rate hikes by the end of the year, judging by the graphic below, equity markets have been split when it comes to price action following an interest rate decision.
With this in mind, it is important to remember that past performance does not guarantee future results. Historically, there is an initial knee-jerk reaction in one direction following the announcement, but the more meaningful price action typically comes during the press conference and Q&A from Fed Chairman, Jay Powell. The reason behind this is that the announcement of a rate hike is something that is normally priced into the markets weeks, if not months, in advance and the markets generally have a pretty good idea of what the Fed is going to do. However, the press conference that follows the rate hike announcement gives market participants significantly more insight into the sentiment of the FOMC voting members as well as some forward-looking guidance in terms of what the FOMC voting members feel are appropriate monetary policy decisions at upcoming meetings. Furthermore, the Q&A session allows media members to press Powell into answering questions that were not addressed in the press release or the press conference. With all of that said, we anticipate that the Fed will likely hike interest rates at every remaining meeting in 2022 but we will be paying particular attention to what Powell has to say in the subsequent press conferences. We believe that the markets are pricing in more rate hikes throughout the rest of the year but what Powell and the Fed say in terms of guidance for the rest of this year and beyond will almost certainly have more of a market moving impact than the actual rate hike announcement.
Mid-Term Election Preview
As we head into the final month of the 3rd quarter, arguably the most important event on the horizon is the upcoming mid-term elections, which will take place on November 8th. As it sits right now, the current makeup of the Senate includes 50 Republicans, 48 Democrats and 2 Independents, who typically vote inline with Democrats, meaning that in the event of a deadlocked Senate, Vice President Kamala Harris acts as a tiebreaker, providing Democrats with the narrowest of majorities. In the House of Representatives, the Democrats majority is a little more comfortable with Democrats holding 221 seats compared to Republicans 212 seats. However, all 435 seats in the House of Representatives and 35 seats in the Senate are up for election come November, which means that we could see a very different makeup in Congress for the final two years of Biden’s presidency. Looking at the graphic below, of the 35 Senate seats that are up for election in November, 14 are currently held by Democrats while 21 are currently held by Republicans.
While we will have to wait until November to see what the new makeup of Congress will look like, let’s take a look at how equities perform under different Congressional regimes. Looking at the graphics below, equity markets have historically performed better during times of a split Congress, with markets averaging 13.3% returns under a split regime (green bar in the first graphic). Furthermore, it should be noted that the worst stock market performance has been when both chambers of Congress and the President are controlled by the same party with an entirely Democratic-controlled government averaging returns of 5.6% while a Republican-controlled government has seen average market returns of 5.7%. With that in mind, depending on what source you look at, it looks like Republicans will gain the majority in at least one of the chambers of Congress, with the most likely outcome being that Democrats retain control of the Senate while Republicans regain control of the House of Representatives.
Looking at the 2nd graphic above, which shows the annual stock market performance based on the president, some of the best returns were seen when we had a Democratic president while both chambers of Congress were controlled by Republicans during the Clinton administration. Additionally, the most positive equity returns under the Obama administration came during his 2nd term when Congress was split with a Democrat-controlled Senate and Republican-controlled House of Representatives. Democrats would argue that their propensity to spend enormous amounts of money in order to stimulate the economy is ideal, while Republicans would argue that lower taxes and lowering our national debt is what is best for the overall health of the economy. While there are differing philosophies behind why a split Congress yields superior equity returns, it is widely believed that a divided Congress forces Republicans and Democrats to come together on issues instead of just ramming partisan bills through government without much resistance. A divided government forces both parties to negotiate and make concessions on both sides in order to reach what is supposed to be the optimal outcome. To wrap this discussion up, in just over two months we will learn the outcome of the mid-term elections. From there, we will have a better idea of what the final two years of Biden’s current term will look like and what the adjustments need to be made to our portfolios to position them accordingly.
As we enter the final month of the 3rd quarter, there are plenty of headlines that we will continue to monitor as they could have significant impacts on the financial markets. Following the month of August when the Fed did not have a scheduled meeting to discuss the economy and monetary policy, all eyes will be on what the Fed does at their September 21st FOMC meeting. It is widely believed that they will raise interest rates by 75bps, so, as we mentioned earlier, we will be keeping a particularly close eye on what Fed Chairman Powell has to say at the press conference following the announcement. Following September’s FOMC meeting, we will get one more rate decision on November 2nd before we head into mid-term elections. With millions of Americans feeling the negative impacts of inflation, combined with interest rates at levels that we have not seen in quite some time sending equity markets back into a downward trend towards June’s lows, November’s mid-term elections are that much more important. As we finish out the 3rd quarter and head into the final quarter of 2022, we are working internally to prepare for any and all scenarios as we attempt to position our portfolios in a way that will be able to sufficiently navigate what is undoubtedly going to be a volatile final four months of the year. The month of August saw us raise our cash levels slightly across our portfolios and we have the ability to raise those cash levels even more if we feel as though that is warranted. Additionally, we will continue to revise our watchlist with companies that meet our investment criteria and will use periods of broad market weakness to deploy the cash that we have sitting on the sidelines into names that we feel are undervalued. Finally, with plenty of market-moving catalysts on the horizon, we will certainly keep everyone apprised on any and all developments that warrant bringing to your attention.
Please feel free to reach out with any questions or concerns!