QUARTERLY UPDATES - Coral Gables Trust Company

Hawkish Federal Reserve vs. Dollar Dominance


Q3 2022 - Balancing Act: Hawkish Federal Reserve vs. Dollar Dominance 
Markets completed another difficult quarter driven largely by inflation and the Federal Reserve's response of tighter monetary policy that seems to have no end in sight. There has not been a place to hide as market participants face a recalibration of interest rate expectations by central bankers across the globe and are left confused by where interest rates might be headed and for how long. As a result, it has been a difficult year with the S&P 500, the technology heavy NASDAQ and the DOW all entering bear market territory in the third quarter with returns of -4.89%, -3.91%, and -6.17%, respectively. Where the market ends this year depends on the evolution of inflation, bond market behavior, health of corporate earnings and anything positive coming out of the Russia-Ukraine war.  Additionally, any clarity on an eventual end to interest hikes will do a great deal to calm investor nerves.

Investors are anxiously awaiting third quarter earnings season to determine whether this will be the season when economic weakness translates to earnings weakness. Market participants caught an alarming glimpse at third quarter earnings with Fed-Ex's earnings highlighting a weakening global environment, thus leading to the removal of their forward guidance. This led to a swift decline in the broader market as investors began to feel the pressure of a possible recession becoming reality. The estimated earnings growth rate for S&P 500 earnings for third quarter is +5.00%. However, if the energy sector is excluded, earnings are expected to be down nearly -2.00%. The chart below illustrates how the the earnings trajectory has been decidedly down since the beginning of the year.

Sources: Charles Schwab, Refinitiv

Third quarter estimates have fallen by more than 11.00% from their peak in June, while fourth quarter estimates have been revised lower by more than half from their peak at the start of the year. The real question becomes; have earnings expectations fallen enough for the market to get comfortable with? While earnings growth remains a key underpinning of stock prices, earnings also need to reflect the reality of the current economic environment. If they don't, it will prolong the correction and keep volatility elevated.

The Federal Reserve's crusade to crush inflation is being felt across the globe, as a strengthening U.S. dollar is boosting inflation and inflation expectations in other countries.  The dollar has strengthened dramatically over the course of the year and is up nearly +17.00%. This has forced the hand of central banks to abruptly tighten monetary policy to avoid an erosion of their own credibility and currency. With a Federal Reserve backstop out of the question, investors remain troubled by the effects of a significantly more hawkish Federal Reserve. At September's Federal Reserve meeting, the committee outlined a more aggressive path of rate hikes through 2023 to combat the multi-decade level of inflation and will continue to increase rates until they feel the appropriate terminal rate has been reached. With the Fed Funds rate currently at 3.25%, expectations call for another 1.25% to 1.50% in interest rate hikes by early 2023. Chairman Powell made it clear that the Federal Reserve is willing to tip the economy into recession if that was required to get inflation back to its 2.00% mandate. The chart below illustrates the rapid pace of tightening, surpassing the 1980's hiking cycle. With inflation currently at 8.30% and a Federal Reserve inflation target of 2.00%, they are desperately trying to cool down the economy by tightening financial conditions. However, the lagging effects of monetary policy through changes in interest rates can take a year or more before they significantly impact the economy.

Source: Bloomberg Federal Funds Target Rate - Upper Bound (FDTR Index), using monthly data 

On the economic front, the third quarter showed plenty of momentum in the U.S. labor market with the addition of 315,000 jobs. The unemployment rate increased slightly 3.70%.  Despite the increase in the unemployment rate showing more workers entering the labor force, we are still seeing a shortage of workers across every sector with the greatest disparities in healthcare and education. It is quite remarkable to see employers retain their hunger for hiring after two quarters of negative real GDP growth. Although, we expect job openings to gradually decline over the next few months as companies will soon experience slowing demand and will no longer be able to justify their current hiring appetite. Notably, this excess demand for workers is playing a critical role in extending the current economic expansion, which is the exact opposite response the Federal Reserve wants to see. 

Housing demand in the economy will be negatively affected by higher mortgage rates.  What started out as a post-pandemic bull market has turned into an affordability crisis for an increasing number of buyers relying on traditional financing. Suppressed inventories, bidding wars and hotter demand fueled a perfect storm for surging home prices and sales.  It has been remarkable to watch the 30-year fixed mortgage rate start the year at 3.00% and rise to nearly 7.00% in just nine months. A recent report by the Federal Reserve Bank of Atlanta illustrated that homes were even less affordable today than they were at the height of the housing bubble in 2006. As shown below, the number of new homes sold between $150,000 - $200,000 has completely disappeared, while sales have favored those selling above $500,000. 

Source: Charles Schwab, St. Louis Fed

Fixed income, historically, has been a uninspiring asset class to talk about but 2022 has been anything but routine. In prior years of market declines, investors have become accustomed to some level of protection from the bond market. This simply has not been the case with the Bloomberg Barclays Aggregate Bond Index off to its worst start in history, down more than -14.61% through the third quarter. The good news is that bond yields are approaching multi-year highs. The yield on the Bloomberg Barclays Aggregate Bond Index stands at a yield-to-worst of 5.57%, which is the highest level since June 2009. During the pandemic when the Federal Reserve set short-term interest rates to zero and signaled it was going to support the economy, it encouraged investors to move into risker assets when searching for yield. Essentially, this dampened bond market volatility causing a rally across the asset class. Now the pendulum is swinging in the opposite direction with the Federal Reserve tightening monetary policy by increasing interest rates. With the rapid rise in interest rates this year, we suggest extending duration modestly into high-quality issues to lock in higher yields. Higher bond yields will undoubtedly create competition to equities in the short-term.

Across the pond, the skies continue to darken as business activity is expected to slow substantially in the coming months as high energy and food prices will curb spending power. With natural gas prices continuing to soar, this means inflation will likely stay close to 10% for the remainder of the year. As winter heating season swiftly approaches, it is unsettling to watch natural gas prices remain almost 10 times their pre-crisis levels. This is clearly a result of the Russian-Ukraine war and inflated prices may not be the worst of it. Energy rationing may be necessary this winter, which would very likely throw the Eurozone into a sharp recession rather than a mild one. With the eurozone facing headwinds from monetary tightening, rising inflation and currency weakness, this will continue to weigh on stock prices overseas in the short to medium-term. However, with developed and emerging international markets trading near or below their 10-year average valuations combined with their favorable diversification benefits, investors have a compelling case for inclusion within portfolios. Additionally, any dollar weakness in the future will act as a tailwind for U.S. investors in foreign investment strategies. The MSCI ACWI ex-US index returned -9.09%, the MSCI EAFE index returned -9.26% and the MSCI Emerging Markets returned -11.46% for the third quarter of 2022.

History illustrates that financial markets have demonstrated a remarkable ability to anticipate a better tomorrow even when today's news is so disappointing. While no one can predict the future and no two market declines are the same, we have been here before and we have learned to hunker down and remain patient during these volatile episodes only to prosper when markets recover. It is well known that the most money is made in markets when conditions go "from bad to less bad" as pessimism gives way to optimism.  Furthermore, markets typically find a sustainable bottom well in advance of any "all clear" signal. The chart below illustrates that market disturbances are a fact of life, but can be an investor's friend, provided they remain calm, patient and focused on the long-term.

Source: MSCI

September was a painful reminder that financial markets are not out of the woods yet in what has been a very challenging year. Investors have witnessed typical bear market behavior by experiencing two broad sell-offs with a strong rally in the middle of each pullback. Volatility will continue until there is more clarity on inflation turning the corner and heading lower on a sustained basis. Our Investment Committee continues to be vigilant and is continuously monitoring the markets and economy. We continue to advise our clients on the need to take a long-term approach to their portfolio that aligns with their well thought out financial plan. Our Investment Committee believes that our current managers are poised to benefit from long-term and attractive investment themes. Our investment managers continue to focus on strong corporate fundamentals in their security selection and are continuously looking for opportunity among the volatility. Listed below is a subset of our equity and fixed income managers that outperformed their stated benchmarks during the quarter. 

We look forward to speaking with each of you regarding our views and the performance of your respective portfolios. For additional information or questions please contact Mason Williams, Chief Investment Officer, at 786-497-1214 or Michael Unger, Investment Officer, at 786-292-0310.

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