Market Recap

After a very difficult first half of the year, equity markets rebounded in July and August on investor hopes of an easing in inflation and a Fed pivot or pause. The reprieve was short-lived however, as stocks tumbled to fresh lows in late September amid further aggressive central bank rate hikes and statements of further tightening to come.

Global stocks (MSCI ACWI Index) fell 6.82% for the quarter and are down 25.63% for the year. The S&P 500 dropped 4.88% for the quarter and is down 23.87% for the year. Developed international markets (MSCI EAFE Index) fell 9.36% for the quarter and 27.09% YTD. Emerging Market stocks (MSCI Emerging Markets Index) dropped 11.57% for the quarter, and down 27.16% YTD. Foreign stock market returns were negatively impacted by the sharp appreciation of the dollar. The U.S. Dollar Index was up 7.1% for the quarter and a stunning 17.3% on the year, hitting a 20-year high (for US based investors, a stronger US dollar is a headwind to foreign equity returns).

Core investment-grade bonds didn’t avoid the Q3 carnage. The 10-year Treasury yield hit a decade high of 3.97%, causing the Bloomberg U.S. Aggregate Bond Index (the “Agg”) to drop 4.75%. This puts the “safe-haven” Agg down an incredible 14.61% for the year to date. In other segments of the fixed-income markets, high-yield bonds (ICE BofA Merrill Lynch U.S. High Yield Index) dropped 0.69% and floating rate loans (Morningstar LSTA Leveraged Loan index) gained 1.37% for the quarter. For the year to date, floating rate loans have been one of the best performers, down just 3.25%.

Trend following managed futures strategies, which have the potential to generate positive returns in both positive and negative equity environments were once again standout performers, posting gains in the mid-single digits over the quarter, and returning 23% to 47% for the year, depending on the fund.

Investment Outlook and Portfolio Positioning

The economic backdrop for the U.S. and global economy deteriorated further in the third quarter. Stubbornly high Inflation remains the key economic indicator. The Fed’s response to the sharp spike in inflation has been to aggressively raise interest rates – their only means of bludgeoning economic activity to reduce aggregate demand and in turn bring inflation in line with their longer-term targets. This has been the catalyst for the steep declines in both stocks and bonds.

While headline CPI inflation (which includes food and energy) seems to have peaked, core inflation measures have continued to rise and are far above the Fed’s 2% target. This indicates inflationary pressures have become more widespread throughout the economy, rather than driven by a few extreme outliers as in 2021.

Some of this broad-based core inflation is still due to the initial “transitory” COVID-related supply-side disruptions and production/distribution bottlenecks, which central banks can’t do anything about. The good news is that many of these supply-chain disruptions are dissipating as the pandemic recedes globally. However, the demand-side drivers of core inflation in the U.S. have not yet peaked, let alone demonstrated the consistent month-over-month declines that Fed Chair Jerome Powell says the Fed is looking for as “clear evidence” inflation is headed to their 2% target. As such, and as expected, the Fed has continued its path of aggressive rate increases and has signaled there is more to come (below):
















The Fed’s policy hammer of higher interest rates will eventually pound down GDP growth and increase unemployment. The odds the Fed can engineer an economic soft landing — where the U.S. economy slows sufficiently to tame inflation but does not fall into a deep recession with much higher unemployment – are increasingly slim. In fact, historically reliable indicators, including the Leading Economic Index (on the following page) and an inverted yield curve, point strongly toward a recession, and that is now my base case scenario for the next 12 months.














While I weigh the evidence as leaning strongly towards a U.S. recession, there are still some positives supporting the economy and that may mitigate the severity of a recession if/when it happens, including a strong labor market, rising wages, and a strong US consumer. Moreover, there doesn’t appear to be any major, systemic economic/financial imbalances (e.g., unlike in 2007/2008).

My focus is on longer-term fundamentals and valuations, and I am not in the business of making shorter term bets on the markets. However, my analysis tells me that at current valuation levels, stocks may not be adequately discounting the potential for further earnings declines, and that has led me to revise some of my underlying assumptions and reduce the returns expected from stocks over my five-year horizon.

At the same time, the sharp increase in interest rates this year has driven bond yields up to more attractive levels – more attractive than they have been in about a decade. On a relative basis, core investment-grade bonds now look much better versus stocks than at the start of the year. Further, core bonds provide good downside protection, which would be especially helpful if conditions turn out to be worse than currently anticipated. For these reasons, I’m making a modest shift to my allocations to increase core bonds and reduce floating rate bonds. It is possible stocks will decline further and reach levels that make them highly attractive for the long-term, and as always, I will be looking at adding to equities at that time.













Closing Thoughts

It’s been a tough year, with most investors (myself included) braced for more to come. But all bear markets come to an end, and it is worth remembering that the bottom is by definition the point at which things collectively feel worst. I think long term and remain confident in my ability to deliver the long-term returns required to meet financial objectives while balancing risk.

When I weigh the shorter-term equity market downside risks and my medium-term (five-year) return expectations across the wide range of scenarios I believe are reasonably probable, I think it makes sense to slightly reduce credit risk in favor of now higher core bond yields along with their better defensive characteristics. The way that I balance risk is by creating diversified portfolios, and many of the investments I hold for this purpose have been bright spots in this tough year. As noted, my overall bond allocation, which includes managers with flexible mandates have outperformed the broader bond market, alongside managed futures, which have delivered significant positive performance.

As always, I thank you for your trust and welcome questions you may have.

Jeff – 10/11/22




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