Quarterly market outlook: Fourth quarter 2022 > edwardjones.com | Member SIPC
GUEST BLOG / By Edward Jones, Co.-- Action for investors. With markets broadly expecting an economic downturn, we think now is a good time to revisit your emergency fund and spending levels. A solid financial foundation can help you weather an economic slowdown. Work with your financial advisor to review your overall financial strategy. Looking back at the 3rd quarter.
Every asset class return in our framework except cash was negative in the quarter. Investors moving into safe-haven assets such as the U.S. dollar pushed the value of the greenback to historically high levels. This was a drag on international performance for U.S. investors. Inflation and monetary policy continue to top investors’ concerns. Markets are now broadly pricing in a contraction in economic growth.
The Fed continues its aggressive policy cycle — The Federal Reserve is expected to hike rates to 4.25% by year-end and keep rates elevated throughout 2023 to combat historically high inflation. High policy rates and softening global economic growth forecasts were a headwind to equity markets, which saw risk asset sell-offs and lower valuations.
Strengthening dollar a drag on international investments — The dollar strengthened to historically high levels for a variety of reasons, including the introduction of the U.K. minibudget, fears of escalation in the Russia-Ukraine war, and souring investor sentiment. The strong dollar meant international equity investments were the worst performers in the quarter, while domestic equities outperformed for U.S. investors. Of the international asset classes in our framework, emerging markets and international small- and mid-cap stocks were the worst performers.
Equity markets reach new lows — The equity market rally early in the quarter quickly reversed, and markets found new lows toward the end of Q3. Technology shares and growth-style stocks, which are more exposed to rising interest rates than value-style shares, have been the hardest-hit this year. Earnings results were mixed during the last earnings season. We expect market volatility to continue until inflation makes significant progress to the downside and the Fed can start to consider pivoting from its aggressive cycle.
Action for Investors. Because equity valuations have adjusted lower and bond yields higher, we believe an allocation in the middle of the equity/ fixed-income range is appropriate. Investors can use the pullback as an opportunity to rebalance portfolios and add quality investments at more favorable prices.
Lingering inflation pressures and the Federal Reserve’s aggressive rate hikes have increased the risks to the economy. Yet a large amount of monetary tightening has already been priced in at a time when inflation may well have peaked. This potentially sets the stage for a gradual market recovery.
Strong headwinds ahead — Higher interest rates, elevated inflation and rising geopolitical risks will continue to pose strong headwinds for consumer spending and economic growth in the quarters ahead. As a result, the risk of a recession is elevated next year, especially if the Fed overtightens policy as growth slows. But absent any major economic imbalances, a potential recession will likely be mild. Household finances are solid, banks are in a strong financial position, and pockets of financial excesses have largely unwound, in our view.
Markets move ahead of the economy — This year’s strong job gains, near-record low unemployment rate and resilient consumer spending are inconsistent with a recession. But the Fed’s aggressive rate hikes have yet to be fully felt throughout the economy, and a slowdown in jobs growth looks inevitable. Stocks move ahead of the economy by about six months. This is why we think the 25% decline in equities since January likely already reflects a mild recessionary outcome. In a less severe downturn, equity markets could stabilize even as economic data underwhelms.
Inflation holds the key — Heading into Q4, we think inflation will determine the direction of the markets. The Fed likely will want to see three or more lower inflation readings to signal a pause. We believe inflation will start to moderate in Q4, driven by improved supply-and-demand dynamics, but only gradually and not in a straight line. Once central banks become less hawkish, both equity and fixed-income markets are likely to mount a sustainable recovery.
Action for Investors. We recommend a neutral allocation to U.S. large caps, with an overweight position in emerging markets and an underweight to small caps. We favor increased allocations within the consumer staples, health care and technology sectors, and reduced allocations to utilities, communication services and materials.
The stock market revisited its lows for the year, with the S&P 500 down 20% to start Q4. While a recession appears likely, a strong labor market, some resiliency in corporate earnings growth and the majority of Fed rate hikes behind us tell us this bear market needn’t last long.
The Fed remains in the driver’s seat — We think we are closer to the end of the Fed’s current tightening campaign than the beginning. Historically, market performance is quite strong 12 and 24 months after the Fed’s policy rate peaks.* We doubt we’ve seen the end of Fed-driven volatility, but we expect moderating inflation in the coming months will provide the Fed some flexibility.
Recovery will be a process, not a point — We believe the market will recover in a “U” shape versus the “V” shaped rebounds we’ve experienced recently. We think the eventual recovery will take some time to materialize, and some traditional recessionary conditions may cause disruptions along the way. We continue to watch for these:
• Several months of consistently declining inflation — Inflation appears to have peaked, but additional months of evidence will be required.
• Resiliency in corporate earnings — With demand slowing, we anticipate downward revisions to corporate earnings estimates, which could trigger further market swings.
• A decline in market valuations — Price-to-earnings metrics have fallen more than 25%, indicating the market has already priced in a moderate recession.
• Widespread pessimism — Consumer and investor sentiment surveys indicate pessimism is already reflected in financial markets. Historically, when these measures reach extremely negative levels, stock market performance has been positive moving forward.
Action for Investors. We see attractive opportunities forming in the fixed-income asset class across bond maturities. We favor U.S. investment-grade bonds, which can offer more stability and exposure to high-quality, longer-duration credits.
Fixed-income markets continued to take their cues from the Federal Reserve and global central banks, as yields moved higher and bond prices moved broadly lower last quarter. The U.S. 10-year Treasury yield, which began the year around 1.5%, moved briefly above 4.0%, its highest level since 2008. Perhaps the silver lining for investors is that the income opportunities and forward returns are becoming more favorable as we head toward a potential peak in yields.
Bond returns after yields peak — Historically, bond returns in the 12 months after a peak in bond yields tend to average over 16%. History also tells us these peaks generally occur about two months ahead of the last Fed rate hike.* In our view, the Fed’s final rate hike will likely occur in December or February, implying that bond yields may be peaking in the weeks ahead.
Consider bond positioning across the curve — Although investors have gravitated toward shorter-duration CDs or one- or two-year bonds, there may now be a more compelling opportunity to add longer-term quality bonds. These bonds not only secure higher income for longer, but also may appreciate if yields eventually start to move lower.
Yield curves still point to economic slowdown ahead — While yields have moved higher, parts of the yield curve have been inverted or negative since mid-July. Although a negative yield curve has been known to signal a slowdown or recession, there tends to be about a six- to 18-month lag before one begins. If the economy does enter a downturn, higher-quality bonds can serve as a buffer and offer income during economic uncertainty.
Action for Investors. While we remain neutral on international developed markets, we see opportunities in emerging markets and recommend an overweight position in emerging market equities to complement domestic portfolio exposure.
International equities have lagged this year amid a surging U.S. dollar and a material slowdown in global growth. Challenges persist, but lower valuations support international portfolio allocations. Also, a stimulative policy backdrop in China could drive more positive emerging-market equity returns moving forward.
Global growth set to end the year weak — Despite increased geopolitical uncertainty, high inflation is forcing central banks to raise rates aggressively. The Federal Reserve is leading this charge, but unique headwinds outside the U.S. suggest international economies will stay under pressure in the near term. Europe is dealing with an energy crisis as the war in Ukraine continues. China is held back by its zero covid policy and a slump in the property sector. It’s hard to predict when these risks could abate, but the challenges are well-known, and fiscal policy support can provide a partial offset until global growth regains its footing.
The surging U.S. dollar is a major drag on returns — With the exception of China and Japan, which are easing policy, most central banks have hiked rates quickly but have not kept up with the Fed. This difference in policies has helped push the U.S. dollar to its highest level in more than 20 years. As it has in the past, the dollar’s strength has weighed on international returns. The silver lining is that because the currency swings appear stretched, even a modest shift in relative drivers away from the dollar could trigger a meaningful trend reversal next year.
Heavily discounted valuations reflect risks — The deeper pullback in international stocks likely already prices in a higher likelihood of recession in Europe and a material slowdown in Chinese economic growth. In our view, depressed valuations provide a reason to maintain international allocations. International stocks could outperform next year if we see a softening in the U.S. dollar (if the Fed pauses its rate hikes in 2023), a shift in China’s zero-COVID policy, or an easing of Europe’s energy crisis.
Midterm elections: 3 key questions
Action for investors. Overall, politics tend not to have a substantial impact on longterm market returns. This year, the post-midterm election period may coincide with a potential moderation in inflation and pause in Fed rate hikes, which in our view will likely be the bigger drivers of market performance in the year ahead
1. What are midterm elections, and why are they significant? The U.S. midterm elections — scheduled for Tuesday, Nov. 8, this year — typically focus on the legislative arm of government, the House of Representatives and the Senate. While all 435 House seats are up for election, only about one-third of Senate seats (35 this year) are up for vote. Historically, the president’s party tends to lose seats during midterms, especially in the House.
2. What issues are voters and policymakers most focused on this year? Top economic concerns for voters this year include uncertainty about the economy and inflation, while social issues such as immigration and abortion rights could also drive voters to the polls. If Democrats maintain power, they have outlined a post-midterm agenda focused on voting and abortion rights, as well as policies to expand Medicare and increase minimum wages. Meanwhile, the Republicans have vowed to focus on a platform that includes battling inflation and immigration reform. However, the likelihood of a split Congress remains high, in which case both parties will struggle to pass any meaningful new legislation or reform.
3. How have markets typically performed around midterm elections, and do they prefer a certain outcome? Historically, market performance in the 12 months prior to midterm elections tends to be mixed, with elevated levels of volatility. On average, since 1960, S&P 500 returns have been around 0.3% in the year leading up to elections. However, performance in the 12 months after midterms is generally consistent: Market returns are positive by an average of about 16%. This is the case regardless of the election outcome or whether one party maintains control. In some cases, markets may prefer gridlock (split White House and Congress by political party) as this likely means little or no new legislation or regulation, giving corporations more clarity for planning.
Investment performance benchmarks.
It’s natural to compare your portfolio’s performance to market performance benchmarks, but it’s important to put this information in the right context and understand the mix of investments you own. Talk with your financial advisor about any next steps for your portfolio to help you stay on track toward your long-term goals.