World stock markets moved significantly lower during the quarter, making that three quarters in a row, an accomplishment not seen since 2009. The S&P 500 Index fell 4.9%, the NASDAQ composite dropped 3.9%, the Dow Jones Industrial Average declined 6.2%, the MSCI All Country World Index fell 6.7% and the Bloomberg U.S. Aggregate Bond Index moved lower by 4.8%. US Treasury rates continued their 2022 surge during the last quarter across the yield curve; the two-year treasury began the quarter at 2.95% and finished at 4.3%. Five-year treasury rates surged from 3.04% to 4.1% and the ten- year treasury rates rose from 3.01% to end the quarter at 3.8%. Yes, the yield curve is inverted and yes that does not bode well for the strength of the economy for the balance of 2022. Curve inversion from the three-month bill to the ten-year note continuing over the course of three months is a historically more reliable indication of a forthcoming recession, we are not there, yet.
As noted last quarter: The Federal Reserve continued with its combined quantitative tightening (reducing the size of its balance sheet aka. ‘balance sheet normalization’) and most recently raising rates 75 basis points with yet another 75 basis points rise anticipated later next month. The question in the minds of many is whether these 50/75 basis points move(s) will continue at future Federal Open Market Committee (FOMC) meetings for the balance of 2022 and into 2023, or not. Historically, in the face of rampant inflation, the FOMC continues to tighten until they ‘break something’, even if this results in a recession. This time may be different in the sense that the FOMC may break multiple ‘somethings’. First on the list, the UK Gilt market. Coming up a close second might well be the Chinese currency, or even the US mortgage market, but not yet. Recall, US 30-year mortgage rates were 2.9% in late 2021 and are now 6.3%.
The FOMC has hiked interest rates further and faster than anytime in modern history. US Bond market losses in 2022 rival the debacle in bond markets of 1920, 1931 and 1940. It is quite possible the FOMC will target a 5% Federal Funds market in 2023 before declining as the Core PCE Deflator (the FOMC’s favorite inflation indicator) is projected to stay elevated at 4.5% at year-end 2022, falling to 3.1% in late 2023 and 2.3% in 2024.
As we have stated in prior quarterly reviews, market volatility will likely continue for the balance of the year and well into 2023. We are concerned about a global equity and fixed income market correction of even more substance than has already occurred and continue into 2023. Even with broad declines in equity prices year-to-date, valuations remain elevated. Comparative valuations to the 1999/2000 overvalued equity markets cannot be and should not be ignored. Intermittent ‘bear market’ rallies of considerable magnitude (as we saw in August) and subsequent declines thereafter might well be the norm for the balance of 2022 and into 2023. While fixed income rates have climbed, the interest rate spread for investment and non-investment grade securities still does not reflect realities in today’s inflation fueled economy. The dollar has surged this year; it now stands near its highest levels in decades versus major currencies like the euro, the British pound and Japanese yen.
And we repeat: The impact of the war in Ukraine cannot be assimilated into the global economy with any degree of confidence. The human and economic tragedies are reminiscent of World War II. Moreover, profits at US multinational companies will continue to be negatively affected by the strong dollar, the war and the resultant slowing of economies in Europe. These horrors and the aftermath of the pandemic means caution in the global markets continues to be warranted, especially given the periodic emergence of new Covid variants.
Our continuing search for and investment in undervalued assets requires patience and a healthy dose of optimism for humanity.