2022 Q3 Market Commentary: Getting the Volume Just Right

Oct 11, 2022 | Market Updates

Do you know people with eclectic musical tastes? I do, and they are ages six and three. My daughters may belt out the soundtrack to Encanto, but they request the Red Hot Chili Peppers or Garth Brooks just as often. It is hard to get the volume just right as my “Daddy DJ” list switches between the rhythmic and vocal oriented music of Disney to the distorted rock guitars of the Chili Peppers. As a result of the frequent musical genre changes, I find myself consistently adjusting the volume knob on the car or home stereo so that the music is neither too loud nor too soft—to protect their hearing of course, but mostly because the girls want to be able to hear the music over their own (inventive) vocals. 

Similarly, Jerome Powell, Chairman of the Federal Reserve, and his fellow members of the Federal Open Market Committee (FOMC) are trying to get the volume just right on the economy. After the Great Recession of 2008, the economy went through a slow recovery. In response, the Fed kept the volume on interest rates near zero. Now, after an extended period of loose monetary policy, fiscal stimulus from the COVID-19 pandemic, and supply chain disruptions, we are experiencing high inflation. It is the Fed’s job to control inflation, so when higher than expected inflation occurs, the Fed begins to dial the knob up on interest rates. 

Historically, interest rate manipulation by The Fed has put the U.S. economy in a precarious situation; if the FOMC turns rates up too high and/or too quickly, it can push the economy into recession. Inversely, if the interest rate volume is turned up too slowly, inflation will continue to be a persistent drag on consumers and businesses. The Fed is trying to find the right equilibrium, which takes time and patience. When it comes to interest rate policy, it has never been easy to get the volume just right. 

What Happened in the Third Quarter of 2022

Since March, the Fed has turned up the volume on interest rates resulting in an erratic and disappointing market performance for the third quarter of 2022. The S&P 500 started Q3 with a strong rebound through the middle of August, only to give back all the gains and then some by quarter’s end, setting a new low for 2022 and becoming the third consecutive quarterly loss for the U.S. stock market. Because the state of the economy in Q3 was not radically different than it was in Q2, we can pinpoint the Fed’s amplified response to inflation as the primary cause of this volatility. 

The Current State of the Economy

Since the U.S. economy is not significantly different than it was at the end of the previous quarter, it seems like we have been playing “We Don’t Talk About Bruno” on repeat. Although growth is slowing, the earnings growth estimate for large company stocks is a respectable 7.4% for the next year. Unemployment remains low at 3.7%, and consumers are still spending money at a year-over-year growth rate of 9.1%. At this moment, positive corporate earnings and consumer unemployment data coupled with a poor macroeconomic landscape clearly suggests that the US economy is in a growth recession. What is not certain is if the Federal Reserve will increase the interest rate volume too quickly and cause a deeper recession in 2023. 

The Fed’s Actions Year-to-Date

What concerns investors most is the speed of the Fed’s significant amplification of interest rates. The FOMC has been dialing up the volume rapidly this year. In September, the FOMC voted unanimously to increase the fed funds rate by 0.75%, citing job gains, low unemployment, and high inflation (exacerbated by Russia’s war on Ukraine).

Historically, the Federal Reserve has followed two distinct strategies for raising interest rates: low-and-slow rate increases and loud-and-fast rate increases. We have experienced a low-and slow approach before: Fed Chairman Alan Greenspan adopted it in 1994-1995 when the FOMC raised the Federal Funds rate by approximately 3% over 13 months (an average of 0.25% per month). The low-and-slow route is a controlled way to increase the federal funds rate, allowing the Fed to gauge any negative changes to the U.S. economy. The Federal Reserve prefers the low-and-slow route—if inflation is under control.

When the Fed feels that inflation is out of control, the FOMC historically applies a loud-and-fast interest rate increase. The loud-and-fast rate increase strategy is quick and painful, leaving us no choice but to cover our ears. The most well-known instance of the loud-and-fast approach was when Paul Vokler’s Fed famously raised the federal funds effective rate from 11.25% in August 1979 to a peak of 19.02% in January 1981. 

The strategy for the current Federal Reserve lies somewhere between the Greenspan and Volker strategies. The rate at which the Fed Funds rate is increasing is Vokleresque, averaging a half-percent increase per month. However, our current rate environment is much more accommodative than either Greenspan or Volker experienced: we started the year with the volume knob at 0-0.25% and the dial currently reads 3.00-3.25%, with an expected peak of 4.6%. As a result, there is currently much less financial pressure on the markets than in the mid 1980s and mid 1990s. So, while consumers may be tired of listening to Encanto (again) at this volume level, we are not yet running for our earplugs. 

The Fed rate hikes have been aggressive, largely because it waited so long to start raising rates. This is not unusual; the Fed is typically slow to increase interest rates when the economy is overheated and slow to reduce rates when the economy is slowing down. With three 0.75% rate increases in a row, the Fed is finally starting to catch up, and there is evidence that it is working to slow inflation. With commodity prices rolling over, including oil falling 35% from its peak on March 8, inflation is expected to begin normalizing towards the target inflation rate of 2-3%. The FOMC will likely start turning the volume down on interest rates through 2023.

In our last quarterly market update, we stated that we are likely in a recession already, albeit a “Growth Recession.” In addition to evidence of negative GDP growth in the first two quarters of 2022, economic indicators such as the inverted yield curve and the Conference Board’s Leading Economic Index now corroborate that assumption, yet fundamentals such as corporate earnings and unemployment remain strong. Is the recession something investors should be particularly worried about? We do not think so. The economy is cyclical, and recessions are a normal part of that cycle. At the end of each recession is a period of expansion, which is what every long-term investor looks forward to. 

Unfortunately, economic news is worse in other countries. Central banks around the world are responding to surging inflation by raising rates. This effort is not coordinated across multiple countries, causing a constant push and pull in the international currency markets. Russia’s aggression in Ukraine is affecting global energy prices which in turn is affecting factory output in Europe. In addition to a decline in economic activity in Europe, the British Pound dropped to its lowest level since 1985 after the UK government proposed tax cuts, which have since been quickly removed. China’s COVID-19 policies have restricted economic activity, and its housing market is starting to show signs of cracking. While the global economy faces economic challenges, the U.S. economy has weathered these challenges better than most countries which has led to a rising U.S. dollar. The world depends on the United States economy, but the United States is not as dependent on the rest of the world which means we may see a recovery sooner. 

What to Expect in the Fourth Quarter 2022

We expect continued volatility going into the final quarter of 2022. At some point the Fed will be comfortable with the volume level and stop raising interest rates. This action will lead to a degree of certainty in interest rates and markets, which we have not had all year. A cessation of interest rate hikes should be a positive sign that the “Growth Recession” has ended and that the United States has entered an economic expansion.

Is Now a Good Time to Be an Investor?

It just may be a good time to be an investor. The time you want to be in the market is when there is plenty of bad news already baked in. Despite a recession, inflation, and rising interest rates, we believe there is more upside than downside at current market values. Historically some of the best times to invest is when inflation is at a peak, and there are hints that inputs such as food, energy, and commodities are starting to reverse their upward price trends.

During periods of economic uncertainty, it is easy for investors to come up with reasons to be pessimistic. While Main Street is looking unstable, it is important to focus on the fact that we are investing in Wall Street and not Main Street. Most publicly traded companies are massive, are the best financed, and are the best run businesses. 

As a long-term investor, stay the course because it will get better. If you have money to invest and are reluctant to get started, it may be a good time to start averaging into the market. We at GreenUp always recommend a well-diversified portfolio, which is even more important in times of uncertainty since diversification works by controlling risk.

Having a well-diversified investment portfolio and a financial plan makes recessionary periods like this one less stressful. It allows us to see beyond the temporary recessions and bear markets and avoid making poor investment decisions. As the wise founder of Vanguard John C. Bogle said, “Time is your friend; impulse is your enemy.”

Summary

  • To fight inflation, the Federal Reserve (the Fed) is raising interest rates. If the Fed turns raises rates too high and/or too quickly, it can push the economy into recession. Inversely, if rates rise too slowly, inflation will continue to be a persistent drag on consumers and businesses.
  • Because the state of the economy in Q3 was not radically different than it was in Q2, we can pinpoint the Fed’s response to inflation as the primary cause of disappointing market performance.
  • At this moment, positive corporate earnings and consumer unemployment data coupled with a poor macroeconomic landscape clearly suggests that the US economy is in a growth recession. What is not certain is if the Federal Reserve will increase interest rates too quickly and cause a deeper recession in 2023.
  • With three 0.75% rate increases in a row, inflation is expected to begin normalizing towards the target inflation rate of 2-3%. 
  • The economy is cyclical, and recessions are a normal part of that cycle. At the end of each recession is a period of expansion, which is what every long-term investor looks forward to.
  • Despite a recession, inflation, and rising interest rates, we believe there is more upside than downside at current market values. Having a well-diversified investment portfolio and a financial plan makes recessionary periods like this one less stressful.

GreenUp Model Updates

Active Allocation Models (Capital Appreciation, Growth, Balanced, Capital Preservation)

For the equities portion of the portfolios, we reduced exposure to small cap growth by selling Alger Weatherbie Specialized Growth Fund (ASMZX) and reduced holdings in iShares Semiconductor ETF (SOXX), iShares US Medical Devices ETF (IHI), and US Global Jets ETF (JETS). We increased the weighting of Invesco QQQ Trust (QQQ) and Avantis International Equity ETF (AVDE).

In the fixed income portion, we bought iShares 20+ Year Treasury Bond ETF (TLT), iShares Core US Aggregate Bond ETF (AGG), Thompson Bond Fund (THOPX), and iShares iBoxx High Yield Corp Bd ETF (HYG), while reducing the weighting of Invesco Senior Loan ETF (BKLN) and Counterpoint Tactical Income Fund (CPITX).

Large Cap Stock Model

We sold CVS Health Corp (CVS), Sanofi SA (SNY), Netflix (NFLX), and Roblox (RBLX) and bought AmerisourceBergen Corp (ABC) and Analog Devices (ADI).

Tactical Equity Model

The quarterly trend has remained negative since March 4. We remain in cash with periodic trades in and out of the market.

The performance of market indexes is discussed as indexes are generally well recognized as indicators or representations of the stock market or certain sectors. Market index performance does not normally reflect reinvestment of dividends or expenses, and you cannot typically invest in a market index. GreenUp Wealth Management may discuss and display, charts, graphs, formulas, and stock picks which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. Consultation with a licensed financial professional is strongly suggested. 

The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass.

GreenUp Wealth Management is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

Author

  • Daniel Greulich, CFA, CFP®

    Chief Investment Officer | Wealth Advisor | Ann Arbor, MI -- Daniel leads our Investment Committee and partners with Aaron Kirsch, Chief Client Advocacy Officer to design and implement client portfolios with your advisor. Daniel brings 14 years of practical experience as a trader, financial advisor, and money manager at both large and mid-sized financial services companies to GreenUp Wealth Management. In addition, he holds a CFP® designation and is also a CFA charterholder. This combination of experience and knowledge helps Dan confidently guide his clients through the development, execution and monitoring of their customized financial plans.

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