Market Review: Despite a snapback rally from mid-June into the middle of August, the third quarter ultimately provided no respite for any asset class other than cash. Within broad equity benchmarks, the Standard and Poor’s 500 Index declined 4.9%, the Russell 2000 Small Cap Index dropped 2.2%, and the MSCI All World ex-U.S. International Index fell 9.8%. Beyond equity categories, the Bloomberg Aggregate Bond Market Index lost 4.8%, Gold fell 8.1%, and the Bloomberg Commodity Index dropped 4.1%. The returns from the beginning of the year were: S&P 500 -23.9%, Russell 2000 -25.1%, MSCI World -26.2%, Bloomberg Bond Index -14.6%, Gold -9.2%, and the Bloomberg Commodity Index +13.6%. The unique challenge of 2022 has been that balanced portfolios have not offered their typical protection as sharply rising rates have negated the diversification benefits of bonds. This environment is truly an outlier. There have been only four previous years during which the S&P 500 and the 10-Year U.S. Treasury have both posted negative returns: 1931, 1941, 1969 and 2018. We are on pace for this to be the fifth year, and the first where both lose more than 10%.
The Fed: The Federal Reserve Board badly misjudged the impact of massive government spending programs and their own easy money policies, and we are now in the midst of the most aggressive policy reversal in four decades. The Fed’s predicament is illustrated by the Core Consumer Price Index, which has moved from 1.6% year-over-year in March 2021 to a just-reported 40-year high of 6.6% for September. The Fed Funds rate is currently 3.25% and the Fed has made it clear it will be materially higher by year-end. The Fed is putting the brakes on growth, particularly rate-sensitive sectors such as housing, but the degree of the slowdown or depth of a recession remains indeterminate. The International Money Fund still currently projects positive GDP in both the U.S. and globally in 2023. Geopolitics are also weighing on markets as Putin becomes increasingly cornered and perhaps more dangerous as his invasion of Ukraine flounders and as China becomes more combative as it relates to Taiwan and the South China Sea. Finally, the surging U.S. dollar is disrupting funding mechanisms overseas, increasing inflation in local currency, and making debt service in our reserve currency more onerous.
Portfolio: As is typical in bear markets, equity market losses have been broad-based and indiscriminate and have therefore offered no havens apart from the energy sector. The macro environment is driving the capital markets and we are in no position to predict the macro much less how asset prices will respond. Our portfolio defense has been your strategic allocation, which is constructed to match your time horizon and goals. Though this is a small consolation when equity performance is poor, our balanced accounts have generated substantial outperformance through downside protection in the fixed income allocation by keeping our exposure to short-term (less interest rate sensitivity) and high-quality (less credit risk) bond investments. Portfolio defensiveness has also been derived from higher cash balances and alternative investments.
Market participants are going through the pain of adjusting to a world where the discount rate, or the risk-free rate, is a real market rate and more consistent with historical norms. We have not experienced this investment backdrop since the mid 00’s prior to the financial crisis, and we look forward to a market where fundamental research is front and center, “factors” such as value, quality, and size have a greater impact on performance, and bonds again offer a role in generating portfolio income. We really do not expect an end to the near-term volatility until the Fed and other central banks have reason to pause and assess the lagging effect of their actions. We will be closely following over the next month how well the market absorbs what should be a parade of leading multinational companies giving tepid earnings guidance as they point to input costs and currency headwinds on their overseas revenue. We will continue to make long-term investment decisions and leverage our experience to take advantage of market dislocations opportunistically and prudently. We thank you for your trust and support through another challenging part of the investment cycle, and we are always available to discuss your portfolio.
YOUR STALEY CAPITAL INVESTMENT TEAM