Equity investors began the third quarter of 2022 with renewed optimism that the worst of the volatility in the financial markets was behind them and pushed the S&P 500^® Index up 9.2% in July. This boost turned out to be a “bear market rally,” as equities sagged with the reality that inflation remained elevated, and the U.S. Federal Reserve was going to remain diligent in its pursuit to tame it. The S&P 500 declined 4.1% in August and 9.2% during September—with the latter marking its worst showing for that month since 2002. As a result, the third quarter ended at new lows for the year. For the quarter, the S&P 500 (down 4.9%) and the Nasdaq (down 3.9%) completed their first three-quarter losing streak since 2009. The Dow Jones Industrial Average (Dow) declined 6.2% for the same period and saw its third consecutive losing quarter for the first time since 2015. Both the S&P 500 and the Nasdaq ended the quarter firmly in “bear market” territory, down 23.9% and 32.0%, respectively.

Some key market-moving events during the quarter included Fed Chairman Jerome Powell’s hawkish speech in August at the Jackson Hole Economic Policy Symposium, the surprising increases in core and headline inflation in September, and the revised Implied Fed Funds Target Rates dot plot released at the Federal Open Market Committee (FOMC) September meeting, which suggests Fed officials are now forecasting higher rates. At present, Fed officials are targeting a range of 4.25% to 4.50% by the end of 2022.

Results in the fixed income markets were only marginally better. The Bloomberg U.S. Aggregate Index declined 4.3% in September and 4.8% for the third quarter, and was down 14.6% for the year-to-date period. The popular investment strategy of maintaining a portfolio with 60% equities and 40% bonds is experiencing its worst year since 1920, with returns down 27%. Historically, it is unusual for both equities and bonds to be down simultaneously.

Even commodities declined in the third quarter. After nine consecutive quarters of increases, West Texas Intermediate oil prices declined by 24.8% and ended below $80 a barrel (though they moved above that level again in October). Copper was down 8.1%, and gold fell 3.4%. The one bright spot was the U.S. dollar, which continued to strengthen and was up 3.8% in the quarter.

As noted in prior issues of Economic & Market Perspective, the volatility in the market is a result of uncertainty, and that certainly remains the case. Mutual of America Capital Management LLC continues to believe that volatility will remain elevated in the fourth quarter and into 2023. The major issues that we are watching include: the Federal Reserve’s ability to tame inflation and avoid a recession, the midterm elections, the U.S. dollar’s strength, and the ongoing war between Russia and Ukraine.

Investors Continue to De-Risk

Given the elevated levels of uncertainty, most stocks struggled during the first nine months of 2022. As noted above, year to date through September 30, the S&P 500 declined 23.9% and the Nasdaq slumped 32.0%, while the Dow fell 19.7%. During the same period, the Russell 1000® Value Index (down 17.8%) outperformed the Russell 1000® Growth Index (down 30.7%) by 12.9%. Given that higher interest rates make future earnings less valuable, it was not surprising to see the value sector continue to outperform the growth sector among large-cap and small-cap equities, as was the case in the first quarter.

Bond Prices Facing Pressure

As we pointed out in the April issue of the Economic & Market Perspective, interest rates have been trending downward since the early 1980s, meaning that bond prices have been in a prolonged “bull market.” This bull market trend is continuing to reverse in 2022, as a host of crosscurrents are making for a volatile year in the U.S. bond market. Year to date through September 30, interest rates across the Treasury yield curve increased anywhere from 187 to 372 basis points. This dramatic move comes in the wake of historically high inflation and the Fed’s pledge to combat higher prices with a series of rate hikes and balance-sheet normalization. The projected pace of monetary tightening, along with hawkish rhetoric from the FOMC, has induced a flattening of the yield curve. The spread between 2-year Treasury and 10-year Treasury yields narrowed by 123 basis points, creating an inverted yield curve of 45 basis points. Sometimes, this can be a precursor for potential economic weakness. On September 21, in the Fed’s quest to bring down inflation running near its highest levels since the 1980s, the central bank approved its third consecutive 0.75-percentage-point rate hike, bringing the Federal Funds Rate up to a range of 3.0% to 3.25%.

Year to date through the end of the third quarter, the 10-year Treasury rose 232 basis points to 3.83% after finishing 2021 at 1.51%. With interest rates rising aggressively, bond prices fell during the same period. The 10-year Treasury was down 16.8%, the 30-year Treasury declined 31.5%, the Bloomberg U.S. Corporate Bond Index fell 18.7%, and the Bloomberg U.S. Aggregate Index declined 14.6%. Although this data reflects just the first nine months of 2022, it’s worth noting that bonds finished 2021 with a negative return, and it is extremely unusual for bonds to have negative returns in back-to-back years. The last time this happened was in 1956.

High Inflation Will Not Go Away

Taking a closer look at inflation, it continues to be problematic in the U.S., and its persistent rise is caused by a variety of factors. These include increases in global commodities, ongoing consumer demand, wage pressures for employers, and lingering supply-chain issues. In September, all three well-known inflation gauges continued to show levels well over the Fed’s average target of 2.0%. 1) The Bureau of Economic Affairs’ Core Personal Consumption Expenditures, the Fed’s preferred inflation gauge, was up 4.9% year over year; 2) the Producer Price Index, which sometimes predicts the direction of consumer prices, was up 8.5%; and 3) the Consumer Price Index (CPI), the most widely recognized gauge, was up 8.2%—which continued to be a multidecade high. The CPI provides a statistical measure of the average change in prices in a fixed-market basket of consumer goods and services. The September CPI marked the 18th consecutive month that inflation was above the Fed’s target rate.

Consumers Continue to Feel Inflation

The ongoing effect of inflation is apparent in many areas of the economy and continues to directly impact consumers’ purchasing power. A major contributor to inflationary pressures has been food prices. The U.S. Department of Agriculture’s (USDA) Economic Research Service updated its August report, which indicated that food prices continue to rise. Economy-wide factors, including ongoing supply-chain issues, as well as energy, transportation and labor costs, have contributed to increases in prices across all food categories. USDA forecasts for consumer food price inflation were increased again in August, with all food prices up 0.8%. Year over year, they are up 11.4%, and at-home prices (i.e., groceries) are up 13.5% through August. By far, the largest increase has been in retail egg prices, which were up 2.9% in August 2022 and 39.8% higher than last August. This increase is due in part to a significant reduction in egg supplies as a result of an ongoing outbreak of highly pathogenic avian influenza (HPAI), which has affected over 44 million birds.

Labor Markets Remain Stubbornly Strong

At the same time, labor costs have also escalated sharply. The Federal Reserve Bank of Atlanta estimates that hourly workers who switched jobs in the last three months received a median pay raise of 8.4%. More importantly, average hourly earnings are up 5.2% year over year. This is not surprising given the high demand for labor and the low supply of workers available.

With the strongest labor market in the last 50 years, the Fed is finding it challenging to bring down inflation. New job creation has been resilient this year, with consistently more than 250,000 individuals being added to payrolls monthly. Between July and September, employers added an average of 371,000 jobs, and the unemployment rate ended the quarter at 3.5%—below the pre-pandemic level and matching the 50-year low. Employment now exceeds its pre-pandemic level and stands at just shy of 160 million people.

Looking at the demand side, the Bureau of Labor Statistics Job Openings and Labor Turnover Survey (JOLTS) for August showed that the number of job openings nationwide was 10 million. This is an indication that the labor market is tight, with a greater supply of jobs than demand. Adding all this together, this is beginning to look and feel like wage-price spiral inflation, where these higher wages will eventually be passed on to consumers from companies needing to pay more to workers. A key to taming inflation is for the Fed to slow the job market, but it must do so in a controlled way, so that the unemployment rate does not spike meaningfully.

Interest-Rate-Sensitive Areas

There are segments of the economy that have begun to show signs of lower prices as interest rates have risen, and these should help ease inflation heading into 2023. The most visible area is a slowdown in commodity prices—especially gasoline, which was in a downward trend since peaking in July at $5.00 per gallon. Through October 3, the national average was $3.82 per gallon. While that price is off the July high, it is still elevated relative to the price a year ago, $3.27. It is also interesting to note that there are considerable differences in prices across the country. As of October 3, the price in California is $5.38, while the price in Texas is $3.19.

One reason the price has declined from its highs in July is the release of one million barrels of oil per day from the Strategic Petroleum Reserve to help to cut gas prices and fight inflation. To date, the reserve has been reduced from 726 million barrels to 450 million barrels—a level not seen since 1984. At some point in the future, the U.S. will need to refill the reserve, which could put upward pressure on the price of gasoline. On the international front, OPEC+ announced on October 5 that it would cut production by one million barrels a day. While that’s viewed as a positive for Saudi Arabia and Russia to keep prices elevated, this move further adds to the challenges faced by countries across the globe, including the U.S., in the outlook for the energy market. As a result, after this announcement, gas prices across the country began to rise again.

In addition to oil, prices of the following major commodities softened year to date, ending September 2022: aluminum (-22%), copper (-22%), silver (-18%), sugar (-2%) and cotton (-17%).

The second area of slowing trends is automobile sales. A combination of higher prices, limited supply and higher financing costs have slowed new vehicle sales to an expected 13.5 million annually. This compares to pre-pandemic annual sales of 17 million vehicles.

In addition, housing has slowed, as it has a direct correlation with higher interest rates. As of September 30, U.S. mortgage rates had risen nearly 1.4% since July, as Treasury yields rose in response to the Fed’s intensified inflation fight. As of October 10, the 30-year fixed mortgage rate was 6.81%, which marked a 16-year high. To put this in perspective, the monthly mortgage payment for an average home costing $375,000, after a 20% down payment, was $1,600 in January 2022. As of September 30, a mortgage on that same house would be $2,550, an increase of $950 per month. Other indications of a slowing housing market are the Mortgage Bankers Association’s measure of national mortgage loan applications, which dropped 2.1% to 170.5 through October 3, the lowest level since 2015; and the gauge of potential refinancing activity, which dropped to 1.8%, a 22-year low.

The Federal Reserve Must Tame Inflation

Since the beginning of 2022, the Fed has switched from what had been an extraordinarily accommodative monetary policy to a hawkish stance. This more aggressive position was reaffirmed in August at the Jackson Hole Economic Policy Symposium. The Fed has hiked interest rates at five straight meetings this year, making it the most active Fed since 2005. But focusing on only the number of moves underestimates just how aggressive they have been. In its latest move in September, the Fed raised interest rates by three-quarters of a point for the third straight time. After this move, the Fed Funds Rates sits at 3.0% to 3.25%—the highest since 2008 after sitting near zero through March of 2022. It is also interesting to note that the Fed has not raised rates by three percentage points in a single year since the 1980s.

In an updated projection, the Fed signaled plans to lift rates by another 1.25 percentage points before the year is over, potentially bringing the federal funds rate to 4.25% to 4.50% before the end of the year. Considering that the Fed only has two meetings left, that could mean another 0.75-basis-point hike in November, followed by a half-point increase in December.

With the Fed’s more aggressive stance on tightening monetary policy to combat stubborn inflation, it is now more likely that the economy contracts and employers pull back hiring in response. When the Fed first spoke about bringing prices down, it had hoped to achieve a soft landing and not induce a recession. More recently, the markets are worried that the Fed will overachieve its objective and tighten too much. Even Chairman Powell noted in his speech on August 26, “While higher interest rates, slower growth and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.” We can assume from his comments that pain is synonymous with recession. According to an October survey by The Wall Street Journal, economists put the probability of a recession within the next 12 months at 63%, up from 49% in a similar survey conducted in July.

Forecasts include that the U.S. economy will enter a recession next year. Estimates for the balance of the year indicated that the Gross Domestic Product (GDP) will show only modest growth, ending the year at 1.7%. However, economists’ forecasts for 2023 are becoming increasingly murky. They now expect the GDP to contract in both the first and second quarters of 2023—which is a downgrade from the last quarterly survey conducted by Bloomberg, which showed modest growth.

Strong Dollar Hurts Earnings

One of the consequences of raising interest rates to fight inflation is that the U.S. dollar has soared relative to other currencies. The Wall Street Journal Dollar Index, which measures the dollar against a basket of other currencies, is up approximately 16% this year through September 30. The dollar’s strength relative to other currencies puts financial pressure on other countries around the world, increasing the cost of imports priced in dollars and servicing dollar-denominated debts. This is particularly difficult for emerging countries that have accumulated large quantities of dollar-denominated debt in recent years. In addition, many of these same countries import much of their fuel, food and other commodities in dollars. Another consequence of a strong dollar is that it hurts U.S. multinational corporations that need to exchange their international sales back into dollars. Within the S&P 500, approximately 29% of sales come from non-U.S. countries. There will be a drag on earnings for these companies, which could lead to lower earnings expectations.

Equity Valuations Contracting

The downward revaluation of equities is a function of high inflation and the Fed’s aggressive response to try to lower inflation by slowing the economy. As a result, investors are requiring a substantially higher risk premium due to higher interest rates and heightened economic uncertainty. Higher rates are causing equities’ price-to-earnings (P/E) multiples to contract, as future cash flows are less valuable when discounted to their present value. This is especially true for longer-duration assets such as growth companies. Growth stocks have experienced a significant reduction in their P/E multiples. The 2023 forward multiple on the S&P 500 Index has contracted, from 21.5 times at the start of the year to 15 times today.

Over the past decade, investors were introduced to the acronym TINA (There Is No Alternative). It is best characterized by an extremely low-yield environment where bonds are unattractive and “there is no alternative” to equities. As a result of the rising interest rates this year, it appears that TINA may not be a long-term investment strategy. While equity prices have fallen significantly in 2022, it appears that valuations are beginning to price in the outlook for the economy. Domestic small-cap stocks appear most attractive as they trade below both their historic P/E multiples and large-cap stock multiples. International stocks have also declined, but the economic outlook in Europe is more challenging than in the U.S.

Outlook

The financial markets continued to experience downward swings in prices due to the heightened level of uncertainty over the first nine months of 2022. As a result, the overall short-to-intermediate-term outlook remains uncertain, and there are several issues impacting the markets and economy that are worth keeping an eye on through the balance of this year. One certain thing is that the Federal Reserve is committed to continuing to raise interest rates to lower inflation.

At the moment, higher interest rates are starting to work their way into the economy. On the positive side, the impact of these higher interest rates is showing, with affected areas so far including the prices of gasoline and commodities, auto sales and the housing market. On the negative side, inflation continues at levels not seen in decades, and continues to have a significant impact on food prices, wages and medical costs.

With all of this in mind, the Fed clearly recognizes that inflation is a major problem, and it is expected to use all the tools in its arsenal to cool the economy and engineer a soft landing while avoiding a recession. We will continue to monitor this, and other important issues that might impact our outlook, in the coming months.

Jamie Zendel is EVP, Head of Quantitative Strategies, and Erik Wennerstrum is VP, Quantitative Research, at Mutual of America Capital Management LLC.

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