📝 Market Commentary for 2022-Q3
This quarter, we look at a negative quarter for all asset classes, economic stagnation, the impact of quantitative tightening, a global "spirit of aggression", and energy-related assets.
We conduct in-depth investment research and provide commentary on the most significant market events of the previous quarter and provide an outlook for the current investing environment.
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No Major Asset Class Produced A Positive Return in Q3 2022.
Source: StockCharts.com
As geopolitical tensions worldwide continued to escalate, the Fed continued to reduce its balance sheet in Q3 2022. The U.S. Dollar's strength gained momentum, and its value increased at an accelerated rate compared to the prior quarter. During a very difficult quarter for most investment managers, not a single asset class produced a positive return. Both financial and real assets suffered alike.
Stagflation Continues to Paint the Economic Picture; Recession Risks Heightened.
Current readings indicate inflation continues to surprise on the upside as commodity prices buoy headline inflation numbers. The projected Q3 2022 GDP, as noted in the Atlanta Fed GDPNow Model, however, remains above the Blue-Chip consensus.
U.S. Treasury Yield Curve and S&P 500 as of 9/30/2022
Source: StockCharts.com
Source: Atlanta Fed
As written in our previous quarter’s commentary, it is my view that the economy of the United States faces a period of stagflation, where inflation remains elevated, and growth remains stagnant, possibly negative at times. Recession risks also remain elevated as the Treasury yield curve in the United States continues to trade inverted, a sign of a recession soon.
Furthermore, statements made by officials of the Federal Reserve suggest that they are prepared to take the chance of a recession to keep inflation down, at least for the time being.
Quantitative Tightening Takes Hold; Financial Market Liquidity Evaporates Globally.
Source: St. Louis Fed
The Federal Reserve continues to reduce its balance sheet by over $100 billion in the third quarter of 2022. As our global financial system is interconnected, it directly impacts the prices of financial assets everywhere, with unintended political ramifications.
A market is said to have sufficient liquidity when there is a healthy equilibrium between the number of buyers and sellers present in the market at any time. It provides participants with access to funds and makes it easier for them to carry out transactions without much cost in time or money. In many respects, it is like water. When there is an abundance of it, we do not give it a second thought; yet, when there is a lack of it, suddenly, it becomes the most important thing. Similarly, the financial markets are only able to function with proper liquidity.
An example of a second-order effect of the Fed’s quantitative tightening was seen with the U.K. Gilt Crisis in late September. The situation began last month when the new (now former) Prime Minister, Liz Truss, revealed a strategy to boost the economy with tax cuts and an energy price cap. Combined with the higher rates of borrowing created globally by the Fed, Gilt investors became concerned about how the British government would pay for its programs. This fear created a sell-off cascade effect in the markets and pension fund sector. This situation became so severe that the Bank of England needed to intervene with a round of quantitative easing and showed what could be possible in this new financial paradigm.
A “Spirit of Aggression” Further Divides the World.
The geopolitical dangers continued to increase during the quarter, particularly Russia's annexation of Ukrainian territory and its threat to use nuclear weapons in its defense. Pelosi's trip to Taiwan during this period incited anger in China, which contributed to an escalation of hostilities in Asia. The United States has reiterated its commitment to defending Taiwan, for the time being. Several other interstate conflicts emerged away from most media coverage. There is a dispute between Azerbaijan and Armenia, and tensions are rising in South America, where Haiti, Cuba, and Venezuela could be the next vector in a proxy war. We have highlighted the potential developing situations in Latin America in previous notes. Russia continues to have disputes with Japan regarding the Kuril Islands as well.
Energy-Related Assets Still Largely in Favor, but a “New Alternative” Emerges to Equities.
I no longer dislike bonds as much as I did last quarter. After a substantial rise in yields and the outlook of slow, if not negative growth, bonds are beginning to exhibit value. Shorter duration assets look more attractive given the risk/reward ratio and will be especially attractive if core inflation pressures moderate. Most equities possess recession risks that haven’t been priced in yet and retain greater downside risk. This, combined with economic concerns for consumer spending, makes bonds a credible alternative to equities after many years of unattractive relative returns.
However, there are certain areas of the stock market that are in better shape than others. Because of ongoing geopolitical events, energy and energy-related assets continue to be a particularly attractive section of the equity market. Additionally, the healthcare industry continues to show positive signs, and the industrial sector could have some interesting developments. This is a sector I have highlighted in since 2020.
The global safe haven continues to be assets domiciled in the United States. The U.S. Dollar, despite the possibility that it is overvalued, is still the safest currency in the world given the global unrest. Despite this, I believe commodities, including gold, can continue to add value to an investment portfolio by being a solid diversifier and hedging against geopolitical volatility.
Written by Joseph Lu, CFA®
Joseph is the founder and managing director of Conscious Capital Advisors and a CFA® Charterholder.
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