Where are We Now? Global Markets at the End of Q3 2022
2022 has been a terrible year for global markets. Almost all stock markets have fallen between 20% and 35% in US dollar terms in the first nine months of 2022. The table below shows the performance of various asset classes as of 30 August 2022.
Global Market Asset Performance YTD
US Indices Performance YTD to 30th September 2022
It has also been a terrible year for bond markets with many indices falling more than 5% as shown below:
Bond Funds YTD Performance
Year-to-Date Total Return for the Bloomberg Global Aggregate Index
The chart in next page shows the annual performance of the Bloomberg Global Aggregate Bond Index. In most years this index gives an annual return in the range of between -5% and + 20%. In 2022 so far it has given a return of almost minus 20%.
Many financial advisors used to recommend their clients a 60/40 portfolio – 60% allocated to stocks and 40% to Bonds. This was thought to be a prudent strategy as in those years when stocks performed badly, bonds would post positive returns. As the data below shows that this portfolio has often given positive returns overall. However, as the table below shows, the performance in 2022 so far is -21%.
60/40 Portfolio: S&P 500 / US 10 Year Treasury (Total Returns, 1928 – 2022)
The reasons for the poor performance of both bonds and stocks are well known. Rising inflation was significantly boosted by the consequences of the Ukraine war (particularly the impact on energy and food prices) and this led to a rise in interest rates and bond yields. Global Central Banks, led by the US Federal Reserve, raised interest rates aggressively in 2022.
Higher US interest rates and bond yields have significantly boosted the dollar. The Dollar Index reached a 20-year high at the end of September 2022. These trends have caused economic and market problems for many countries, both developed and developing.
What is the outlook?
The events in 2002 should make us very reluctant to make any forecasts. The central problem is inflation. As the chart before shows, the US consumer Price Index has risen from around 2% in December 2020 to a peak of 9.1% in June 2022.
It is not just the US. Many other countries in Europe, the UK and elsewhere have seen double-digit inflation rates in 2022.
It goes without saying these inflation rates are unprecedented in recent times. They raise the spectre of the high persistent double-digit inflation in the 1970s and early 1980s which nobody operating in today’s markets has ever experienced.
The US Fed was initially slow in responding to the inflationary threat as the pressures were believed to be transitory. This was clearly not correct and the Federal Reserve has raised interest aggressively starting in March 2022. The Fed Funds Rate has risen from 0.25% to 3.25% in six months. Other Central Banks have followed suit with a lag.
The US interest rate futures market is currently pricing the Fed Funds Rate to rise to about 4.5% in March 2023 before gradually declining. The “Dot Plot” projections given by the Fed FOMC members are somewhat higher than this.
Needless to say inflation remains elevated, current, and prospective interest rates imply investors in deposits and bonds experiencing negative returns in real terms. The markets hope that inflation will fall quite rapidly to below 3% in the next twelve to eighteen months. The markets fear must be that inflation will be persistent and the Fed will have to use rates to create a deep recession before inflation pressure can be decisively removed.
There are some Signs to Support the Bullish Case
Commodity prices have fallen since a peak in June. Other data such as lumber prices and the cost of freight have also fallen significantly. In addition, the various date series for inflation also declined in the last month or so.
However,there is also some evidence of a very strong economy as evidenced by the low unemployment in the USA.
- For bond investors, the worry is that interest rates may rise more than is currently expected and the elevated interest rates may persist for some time.
- For equity investors, the worry is that a prolonged recession will put significant downward pressure on corporate profits.
If the Fed can tackle inflation by increasing interest rates significantly more than is currently expected by the market and avoid a recession, then investment in stocks and bonds at current levels is likely to prove to be a profitable strategy.
What are the Current Valuations of the Stockmarkets?
The S&P 500 has rallied strongly so far in October 2022. At the current level of about 3775, it is on a forward Price Earnings Ratio of 18.5 times. This compares with 24.7 times at the end of 2021 and 30 times at the end of 2020. So, the valuations of stocks have come down significantly in the last two years.
At the current P/E of 18.5 times, it represents an earnings yield of 5.4% (E/P). This is higher than it has been for a long time.
- If longer-term bond yields are at, or below, 3.6% (this is the current 10-year US yield), then stocks at 5.4% earnings yield represent an attractive risk premium over bonds. This would be more significant if there is optimism on corporate earnings which would enable capital appreciation for the stocks.
- On the other hand, if, US bond yields rise from current levels and remain higher (say above 4%) then equities could fall further from current levels.
Therefore, the key element will be inflation, the future path of interest rates and their effect on bond yields. The main risk is that inflation proves to be stronger than expected and the Fed is forced to raise interest rates by much more than is currently expected. This would then lead to a recession which would lower corporate earnings estimates. This is likely to lead to further declines in the stockmarkets.
In our view, we need some evidence that the economy is slowing meaningfully at current interest rate levels before recommending that investors buy stocks. From a longer-term perspective, stocks look at attractive valuations.