Market Commentary - October 2022

Monthly Update

Stocks rebounded sharply in October from the closing low of the year at the end of September for the S&P 500. This index was higher by 8% while the small cap Russell 2000 was the real standout with an 11% rally[1]. The NASDAQ lagged with its 3.9% rise as big cap tech mostly disappointed with their earnings releases[2]. The stock market rally was global as the Euro STOXX 600 index was up by 6.3%, while the Nikkei and Kospi were higher by about 6%[3]. Worries about growth, zero covid and the negative reaction to China’s party Congress with those appointed, the Shanghai comp was lower by 4.3%[4].

Notable in US stocks was the outperformance in the month of value stocks relative to growth as the latter was weighed down by disappointing earnings from many technology stocks. The S&P Value Index was higher by 11.4% in October vs the 4.4% rise for the S&P Growth Index[5].

The rally wasn’t driven by a drop in interest rates, which has been the scourge all year for stocks but on hopes that the pace of central bank driven rate increases will slow in pace, and that just maybe, we’ve seen peak hawkishness. Even so, the 2 yr. US Treasury note yield rose 21 basis points in October after nearly 140 basis point increases over the prior two months[6]. At a closing level of 4.49%, that was the highest since 2007. The 10 yr. yield was up by a similar amount in the month. Overseas, after the wild and scary ride that the UK gilt market went on at the end of September, which saw its 10 yr. yield jump 129 basis points, things calmed down in October as they fell by 58 basis points[7]. At least for now, it seems that the deleveraging in the UK pension system has been enough to reduce the risks of further margin call panics. The UK also saw a new Prime Minister in Rishi Sunak after Liz Truss was quickly disposed of, disappointingly I argue.

Corporate bonds were more mixed in the month as the lowest rung of the high yield sector, that being CCC rate companies, saw further weakness while leveraged loans, most of which are junk rated, were little changed after recent softness. Investment grade traded lower but mostly due to the rise in interest rates which they are very sensitive to because of their historically high durations.

Energy prices, which is a major pain point this year for consumers and many businesses, were mixed as crude oil bounced by 10%, while US natural gas prices were down by 10%[8]. In Europe in particular, the price of natural gas as measured by the Dutch TTF (Title Transfer Facility) index plunged by 49% and closed back to where it was before the Russian invasion of Ukraine. While this is great news of course, and supplies seem ample for the winter, there has been major demand destruction that has also contributed to the fall, particularly in the industrial space where major capacity has gone idle.

Lastly, in terms of market action, the euro/yen heavy US dollar index finally stopped going up as it was little changed, down 0.5%. This comes after the ferocious rally through September of 17%[9]. I continue to be of the opinion that the major reason for the dollar strength this year has been the aggressive Fed and sharp rise in US interest rates relative to other central banks and countries. As we get closer to the end of Fed rate hikes, which I think could end in December, the US dollar is about to lose its bull case at the same time other central banks keep hiking. Evidence of this has been the strong performance of the Mexican peso and Brazilian real this year as their central banks started raising rates in early to mid-2021, well before the Fed.

Central Banks

On November 2^nd, the Federal Reserve raised the fed funds rate by 75 basis points to a new range of 3.75-4%, the 4^th meeting in a row at this amount and while the statement implied that the Fed was going to slow the pace of rate increases from here, the destination still might be the same[10]. This was Jay Powell’s way of balancing the need to acknowledge the lagged impact of their sharp rate increases and at the same time wanting to maintain a tough stance on inflation by saying rates still need to go higher from here.

This very aggressive approach to the inflation that they stoked, along with very large fiscal spending, and the rate shock therapy has a lot of risks involved. With the Fed’s firm commitment to beat inflation down, they themselves acknowledge that the window of a soft landing is closing, and I agree.

The Bank of Canada surprised us in October by raising its benchmark interest rate by 50 basis points to 3.75% instead of expectations of a hike to 4.00%[11]. The Reserve Bank of Australia also has reduced the pace of its rate increases to 25 basis points, and they took their overnight rate to 2.85% a few weeks ago[12]. As expected, the European Central Bank in October raised its deposit rate by 75 basis points to 1.50%, though still remains well below inflation in the region that saw a 10.7% y/o/y increase in consumer prices in October and already some ECB members are getting nervous about sharper rate rises[13].

So, the net result of the above is some central banks are becoming more sensitive to the slowing economic situation and not wanting to overdo it with rate hikes, but at the same time acknowledging that inflation is still too high and rate increases will continue. It’s a very tough needle to thread and I’m not confident that they will all be able to maneuver this smoothly.

Global Economy

The US, the Eurozone, and some economies in Asia all saw positive growth in Q3 but it’s mostly likely just a respite before contraction in Q4, particularly for the US and Europe. For the US specifically, real GDP in the first three quarters of 2022 is essentially unchanged from where the economy stood at the end of 2021. Housing is in a recession as lower income consumers are feeling their own recession and US manufacturing is at best seeing no growth. On the other hand, parts of the services economy like leisure, travel, and hospitality are still experiencing pretty good growth. That same bifurcation is taking place in the labor force where tech related businesses, that over hired in the last few years relative to their current needs, are trimming their workforces, or at least limiting hiring. At the same time, restaurants, airlines, and hotels can’t find enough people.

Europe’s economy is certainly challenged by very high energy prices, although they’ve moderated sharply from their peaks. Part of this is that storage levels are high going into the winter but also it’s due to demand destruction that has dramatically reduced production in many industrial sectors as previously stated. Refilling natural gas storage facilities for the following winter will be even more challenging but we’ll cross that bridge next summer.

China’s economy continues to suffer from its still aggressive zero Covid approach. There are rumors that post party Congress, plans are for a full reopening, likely in March that are beginning to be discussed. For the sake of not just the Chinese people, who have suffered at the hands of this policy, but for the entire global economy, we need to see the Chinese economy free of these covid handcuffs. That said, their residential real estate market, about 30% of GDP, is still suffering a severe downturn and will likely continue to in 2023[14].

Conclusion

Markets in October got a welcome respite from the hopes that we’re coming to the end of interest rate increases, or at least are on the cusp of slowing them down. This belief though got some cold water in early November after Jay Powell spoke at his press conference. Yes, the pace might slow from here, but rates are still going to go higher. What follows is how the global economy handles a higher cost of capital than what we’ve been used to. Inflation has peaked out but should remain persistent and sticky, and that is an environment we are also not used to.

With that said, it is important to remember that recessions and bear markets are a natural part of the business cycle, even though our business cycles have been polluted by central bank activism. As we continue to navigate through this, it remains vital that investors have adequate short-term liquidity over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a challenging time for the economy and markets. Time horizon is very crucial right now and is the best friend of any investor. I want to also finish by saying that in bear markets, both in stocks and bonds, tremendous opportunities are created for those that have cash and the risk appetite to take advantage.

Disclaimer

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[1] Bloomberg

[2] Bloomberg

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[14] Bloomberg