Stock and bond market volatility continued during the 3rd quarter. The S&P 500 Index gained back half of the decline experienced during the first two quarters of the year by mid-August before falling to the lowest levels of the year to end the quarter. The S&P 500 declined 4.89% during the 3rd quarter and is down 23.88% year-to-date. The 10-Year U.S. Treasury Yield dropped early in the quarter before rising to its highest levels since 2011. The 10-year note ended the quarter yielding 3.80%. The U.S. dollar also appreciated markedly relative to other global currencies approaching levels last seen in 2002. As a result, international stocks fared poorly during the quarter when priced in dollar-terms, falling 9.26% for the quarter and resulting in a decline of 26.71% year-to-date.

Inflation continues to be the main focus for the markets and the economy. The Federal Reserve Open Market Committee (FOMC), led by Chair, Jerome Powell, has spent the summer trying to convince markets that it will do what it takes to bring down inflation, even if it means slowing the economy. As evidence of their conviction, the FOMC raised interest rates by 75 basis points (0.75%) twice in the second quarter (July and September). The FOMC and the market expect two more hikes before the end of the year. The cost of energy has declined further and supply chains are much improved, but that has not yet translated into slower price growth in aggregate as other inflation measures continue to rise.

Confounding the FOMC’s efforts is the fact the U.S. economy, until very recently, has performed very well underpinned by a strong consumer. In addition, labor markets remain strong. The most recent reports on unemployment and consumer spending are not consistent with a slowing economy – something the FOMC is looking for as evidence that the rate hikes are taking effect.

On the other hand, global economies have fared worse than the U.S. China is still engaging in a zero-tolerance policy in a world mostly beyond COVID-driven lockdowns. China’s policy is still pressuring supply chains and contributing to some of the inflation in the U.S. The lock-downs have slowed the Chinese economy and have shed light on another developing problem involving their overbuilt and overvalued real estate sector.

Europe faces multiple challenges as a result of the ongoing conflict in the Ukraine, primarily as a consequence of sanctions put in place to pressure Russia to swiftly end the conflict. Russia has retaliated by stopping the flow of natural gas to the region, leading to much tighter supply and higher prices - just in time for winter. Renewable sources of energy are more widely utilized in Europe, but oil and natural gas still make up the majority of their energy mix. Further, a strengthening dollar is also impacting the price of imported goods for Europe. The European Central Bank is faced with having to raise rates to combat inflation in the face of what is likely going to be a relatively severe economic slowdown. A recession is very likely to occur in the U.S., but one is nearly certain to occur in Europe.

Looking Forward

Markets are beginning to fully realize the conviction of the FOMC and have priced investible assets accordingly. Valuations for stocks, as measured by the forward price-to-earnings ratio have declined to levels below the 25 year average. This certainly bodes well for returns in the long-term as expectations have risen since the beginning of the year. In the short-term, however, markets trade on emotion, and the primary emotion prevalent in markets today is fear, so prices certainly may go lower. Interest rates have eclipsed the 4% level in many areas of the market including mortgage rates over 6% for a 30 year loan – which is bad news for borrowers. However, rising rates certainly help investors as a fixed income portfolio now provides meaningful income as part of a balanced portfolio.

There is likely to be more economic pain ahead for the U.S. and the world, but how much to expect is hard to gauge. We are taking a two-pronged approach when positioning portfolios for the short and long-term. We have been allowing cash balances to rise as uncertainty surrounding many economic and geopolitical events may mean continued volatility in the markets. At the same time, we are keeping a bias towards stocks – primarily U.S. stocks. Relatively attractive valuations are compelling for the long-term but we want to balance that with risk-free funds in the event that the market experiences continued choppiness or an unanticipated event alters current expectations in a negative way. Money markets, the most risk-free investment available, are now yielding 3% – not much below the yield on a 10-year U.S. Treasury. We expect that yield to continue to rise as the FOMC continues to increase interest rates, meaning there is very little cost to building cash balances in the short-term compared to last year when interest rates were near zero.

Thank you for allowing us to serve you, it is an honor that we do not take for granted. As always, we are here to answer your questions and make sure your current asset allocation is still appropriate for your circumstances. If it has been a while since you have visited with us, please do not hesitate to call or email and set up a meeting with your Hills Bank Trust and Wealth Management Officer.

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