November 2022 Stonemark Market Commentary

Will Markets Rise as Inflation Falls?

Inflation has taken a big toll on the markets in 2022. Rising prices have emboldened the Federal Reserve to tighten monetary conditions at a historically fast pace, which has sapped demand for risk assets while also raising the cost of capital for individuals and businesses. The amalgamation of interest rate increases and sticky inflation has made for a challenging year for investors. Inflation has also meant increased costs for materials, inventory, and labor for corporations, which erodes the value of current and future earnings. Since stock prices are based on expectations of future earnings, it makes sense that high inflation is undesirable over the long-term for stocks. When considering the trade-off between the short-term pain of tightening financial conditions and the long-term positive of having inflation under control, the latter should always be preferred. Thus, it should make sense that inflation falling from elevated levels generally has been correlated with a positive reaction from equity markets. Since 1960, the Consumer Price Index (which is a key measure of inflation) has gone above 6% on five occasions: 1970, 1974, 1979, 1990, and 2022. In every instance before 2022 when the Consumer Price Index (CPI) peaked and started falling, stocks staged relatively powerful rebounds. The Consumer Price Index measures the year-over-year change in the price of goods and services for consumers, making it a key method to measure changes in purchasing trends and inflation. If we see more signs in the current cycle that inflation has peaked and is beginning to fall, we may see a correlated rise in the markets. The good news: signs of easing inflation pressure continue to appear in economic data.

Will Inflation Falling Prevent a Recession?

The Bureau of Economic Analysis (BEA) reported on October 27 that the economy in the United States grew by an annual rate of 2.6% in the third quarter—a solidly positive number, but one that Vanguard believes overstates the strength of the U.S. economy based on the following:

  • An important forward-looking signal, final sales to private domestic purchasers, grew by just 0.1% compared with the second quarter, down from 0.5% and 2.1% in the two preceding quarters. (That category is the sum of personal consumption, housing, and capital expenditures.) Housing was especially weak.

  • Vanguard also expects below-trend growth of around 1.7% in the fourth quarter, allowing the economy to eke out a gain for the full year, and growth of 0.25% to 0.50%.

  • The Euro area, United Kingdom, and U.S. are the most likely to see a recession by the end of 2023 as the effects of the Ukraine war and global policy tightening weigh heavily on growth and consumers.

Recession in 2023 is now Vanguard’s base case

Equity Market Recap

  • Expectations for a slowdown in the pace of central bank tightening contributed to a second consecutive monthly gain for global stocks.

  • As expected, the Fed hiked interest rates another 75bps in early November. The following week, data showed moderating inflation for the month of October. This news, combined with mounting recession risks, led to growing expectations that the Federal Reserve and other central banks might slow their rate-hike campaigns.

  • Amid this market environment, the S&P 500 Index rallied nearly 6% in November, despite earnings outlooks and year-over-year corporate earnings being generally weakened. Non-U.S. developed markets stocks rose even higher, delivering double-digit monthly gains.

  • All sectors of the S&P 500 Index advanced in November, with the materials sector being the strongest - up nearly 12% - while consumer discretionary was the weakest - up 1%.

  • Over in the United Kingdom, inflation topped 11%, prompting the Bank of England to raise interest rates by 75bps in November. This was the central bank’s largest rate hike since 1989

  • Emerging markets outperformed their developed markets peers, largely due to equity gains in China and easing global commodity prices. Despite widespread protests and the Chinese government’s strict COVID-19 policies and lockdowns, stocks rallied amid expectations for new economic stimulus measures.

Fixed-Income Recap

  • Treasury yields retreated in November, aided by moderating inflation, and tempered rate-hike expectations. U.S. bonds rallied for the month, even as the Fed delivered another 75bps rate hike.

  • The Bloomberg U.S. Aggregate Bond Index advanced 3.7% in November, as all index sectors posted positive returns.

  • Narrowing credit spreads and declining yields helped corporate bonds advance more than 5% to outperform Treasuries and Mortgage-Backed Securities (MBS). Meanwhile, high-yield corporate bonds posted gains, but underperformed investment-grade bonds.

  • Municipal bonds rallied for the month and outperformed Treasuries and the broad U.S. investment-grade bond index.

  • Although five- and ten-year inflation breakeven rates declined in November, Treasury inflation protected securities (TIPS) gained nearly 2%, benefiting from the broad Treasury market rally. However, TIPS underperformed nominal Treasuries, which gained nearly 3%.

  • Softer inflation data and expectations for the Fed to slow its tightening pace pushed Treasury yields lower; the 10-year Treasury yield fell 44bps to 3.61%, while the two-year Treasury yield dropped 15bps to 4.34%. The yield curve remained inverted.

  • Annual headline inflation (as measured by the Consumer Price Index) eased from 8.2% in September to 7.7% in October. Key index components, including food (up 11%), energy (up 18%) and transportation services (up 16%), continued to contribute to the high inflation rate.

What It All Means

The 2022 market has reiterated the need for investors to consider their allocations to the fixed income and equity markets among these changing and dynamic environments. The interest rate environment has created opportunity for some in the fixed income world and exposure to this long-neglected sector should be revisited. As such, it is prudent for all investors to reassess their current fixed income exposure and have subsequent discussions with their advisors about increasing, decreasing, or maintaining current fixed income allocations. Our position on the economy has been that the U.S. is headed for a recession, but we’re not quite there yet. This position remains unchanged, as recent economic data released through employment reports and inflation statistics do not indicate any such changes to a 2023 recession. Investors should expect to see a recession in the early part of the second half of 2023, but possibilities remain for it to come sooner or later in the year. As the market continues to anticipate the looming recession, expect mediocre economic growth and subsequent market performance.

Compiling all the available economic data and fiscal and monetary policy, you have a weakened economy that is still growing but showing signs of wear and tear. We will continue to look for companies with strong balance sheets and high free cash flow in segments of the economy that are less discretionary and more resilient. We are favoring companies that offer solid dividends and return value to shareholders through disciplined C-suite financial decision making. Our team thanks you all for your trust and confidence in this challenging year, and we will continue to manage our way through future market turbulence.