October may just yet mark the beginning of the end for inflationary pressures here in the U.S. The Fed’s relentless pursuit of higher interest rates is starting to take hold, as prices across a wide range of industries are softening, albeit at a slow pace. With the Federal Funds rate now at a 3.00% to 3.25% range, and with the Fed poised to increase by another 75 basis points this week, QT measures are finally taking hold. We would anticipate economic data going forward to reflect a gradually slowing U.S. economy, although one with a still-strong labor market.
Consumer prices edged higher by +0.4% in September for a +8.2% YoY increase. Core CPI surged +0.6% on the month for a higher than expected +6.6% YoY increase. Producer prices remained elevated with PPI registering a +0.4% MoM increase (+8.5% YoY), while Core PPI rose +0.3% MoM and +7.2% YoY. Lastly, the PCE Deflator rose +0.3% in September (+6.2% YoY), while the Core Deflator grew by +0.5% MoM and +5.1% YoY.
The Employment picture remained strong in September with the Unemployment Rate coming in at a lower than expected +3.5%, with Nonfarm Payrolls growing by 263k. Average Hourly Earnings rose +0.3% on the month (+5.0% YoY) while the Labor Force Participation Rate came in slightly lower than expected at 62.3%. Weekly Initial Jobless Claims remained low in October averaging 219k per week. The JOLTS (US Job Openings By Industry Total) showed over 10mm openings in August while the just released September number came in at a higher than expected +10.7mm.
Purchasing Managers Indices continue to hover around the 50 mark (below 50 representing contraction and above 50 expansion). The S&P Global US Manufacturing PMI registered 50.4 in October, up from the prior reading of 49.9, while the ISM Manufacturing PMI came in at 50.2.
As we enter November, the Federal Reserve continues to raise interest rates to combat historically high inflation. Further, the Fed is reducing its balance sheet at an increasing rate, and M2 continues to decline. More restrictive monetary policy should serve to tame inflation in coming months, all the while sending the US economy dangerously close to recession. If the US can maintain stable employment into 2023, the odds of a severe recession would be significantly diminished.
U.S. equities rallied sharply in October, with the benchmark S&P 500 Index gaining +8.1% to close at 3,872. Small- and Mid-Caps, as measured by the Smallcap 600 and Midcap 400 gained +12.4% and +10.5%, respectively, in a broad sign of a risk on rally. Small- and Mid-Caps have outperformed their Large-Cap peers in recent months thanks to greater exposure to the US (Small-Caps garner nearly 80% of their revenues domestically), less impact from a strong US Dollar, and a more Value tilted sector exposure (i.e. less Technology). Taken as a whole, Small- and Mid-Caps are down -13.7% and -13.3%, respectively for the year, more than +400bps ahead of Large-Caps.
From a style perspective, Value continued to outperform Growth during the period, with the S&P 500 Value Index gaining +11.5%, compared to a mere +4.5% for the S&P 500 Growth Index. For the year, Value has returned a relatively strong -7.0%, compared with -27.3% for the S&P 500 Growth Index. That more than 20 percentage point gap has been helped broadly speaking by underlying stocks rather than sector exposure alone. For example, Energy, the year’s top performer up +68.0%, is only an 8.8% weight in the Value Index, not much larger than its 5.3% weight in the broader S&P 500.
At the sector level, the aforementioned Energy sector was the best performer, gaining +25.0% in October as crude oil prices rose and Energy companies recorded record profits. Industrials were the next best performing sector, up +13.9%, while Financials and Healthcare gained +12.0% and +9.7%, respectively. Bottom performing sectors included Communication Services, Consumer Discretionary, Real Estate and Utilities, up +0.14%, +0.23%, +2.04%, and +2.05%, respectively. It’s not surprising that Communication Services (home to Facebook and Google) and Consumer Discretionary (home to Amazon) were at the back of the pack, after their largest constituents reported weak Q3 earnings amidst a global slowdown in advertising spend and cloud computing usage. Real Estate and Utilities lagged due to a broad based rally, and the fact that their relative yield advantages have been diminished from higher interest rates.
From an earnings standpoint, nearly 1/3 of the S&P 500 is scheduled to report this week, after nearly the same amount reported strong results last week. On balance, earnings season has been better than feared, despite negative reactions to 4 of the top 5 largest companies (Apple was the lone positive market reaction after beating estimates on the top and bottom line, and reporting better than expected growth in China). So far this year, estimates for 2023 have come down nearly -6%, from $252 to a recent $235, not far from historical averages. Should that $235 figure hold, it would put the Large-Cap Index at roughly 16.5x next year’s estimates, in line with long-term averages, but above historical trough levels. As we head into year end, the opportunity for a Santa Claus rally remains, but should be greeted with an eye of caution, absent a change in tone from the Federal Reserve, as significant unknowns remain around the impact of higher rates on the economy, and the future state of global growth. Stay tuned.
International equities saw mixed results during the month of October as political drama remained center stage across the globe. Developed Markets (DM) equities, as measured by the MSCI EAFE Index rose by +5.38% on the month while Emerging Markets (EM) equities, as measured by the MSCI EM Index fell by -3.09%.
The continued decline in EM risk assets was largely driven by political concern in China as Xi Jinping secured a norm-breaking third term controlling China’s ruling Communist Party. Chinese markets tumbled on the news that he added six men to his top team– all Xi Jinping loyalists, clearing the path for him to rule with minimal opposition underscoring investors’ concerns that what has shaken markets isn’t an irregularity, but a sign of what’s ahead. The MSCI China Index fell -16.80% during the month of October, bringing the index to a staggering -42.30% fall year-to-date.
In the UK, however, markets were calmed as Prime Minister Liz Truss resigned following a failed tax-cutting budget which had rocked the U.K. bond market prompting emergency intervention from the Bank of England. Markets responded positively when Rishi Sunak, former Chancellor of the Exchequer, was announced as the new U.K. Prime Minister. Mr. Sunak has already signed off on tax increases to shore up the costs of hundreds of billions of pounds spent through the Covid-19 pandemic and massive support for U.K. households’ energy bills. During the month of October, the FTSE 100 Index gained 2.99% in GBP terms and 6.12% in USD terms – highlighting the continued strength of the greenback internationally.
Political drama was also seen in Brazil as former president, Luiz Inácio Lula da Silva beat incumbent Jair Bolsonaro by securing 50.9% of the electorate, marking it the country’s closest presidential race in history. While market participants await direction on fiscal policy from the incoming President, the Brazilian Real climbed 2% against the US Dollar during the final trading day of the month.
Most MSCI ACWI ex U.S. sector’s reversed course in October posting positive gains. Leaders came from Energy (+10.22%), Industrials (+6.63%) & Healthcare (+5.11%), while losses were found in Real Estate (-4.90%), Communication Services (-3.53%) & Consumer Discretionary (-2.05%).
Interest rates moved broadly higher in the month of October. This put downward pressure on bond prices and led to negative returns for most exposures. Treasuries were most impacted, with a -1.38% return for the month. The Aggregate bond index performed similarly, and is heavily weighted towards Treasury market exposure.
High Yield corporate bonds were the standout performer in the month, with a positive return of +2.6%. This was driven by spread tightening specifically to junk bonds. Investment Grade corporate bonds did not experience a similar tailwind, with their spreads roughly flat for the month. With the recent outperformance, High Yield bonds have become one of the better performing fixed income allocations in 2022. With rising debt costs, and default rates beginning to move higher, a slowing economy in 2023 could pose problems for the most levered borrowers in this category.
Investment Grade corporate bond performance declined just over -1% in October, with the additional yield they offer over Treasury bonds being offset by the negative price impact caused by the rise in the yield curve. In 2022, Investment Grade corporates have had a very difficult time. They have been negatively impacted by rising rates and widening credit spreads, but without the additional level of yield provided by junk bonds which has allowed that allocation to earn-out of the negative price impact experienced. Given the underperformance already incurred, and the attractive yield levels on Investment Grade corporates (higher than we have seen in may years), limited Duration exposure broadly makes sense, with longer Duration positions for Asset Liability Matching (ALM) accounts.
Municipal bonds held up well in the month, and have offered a similar return to High Yield in 2022, with less volatility. Many clients look to Municipal bonds for high quality tax-free income, and some ballast in their portfolio to counter equity market volatility. In a tough year for bonds, the case can be made that on a relative basis, municipal bonds have been doing just that.
Jerome Powell’s Federal Reserve Board will meet on Tuesday and Wednesday, with the expectation of another 75 basis point increase in the Federal Funds Rate to be announced on Wednesday afternoon. This will push the target rate up to 3.75% to 4.00%. The market is expecting the Fed to raise rates again in December, but to a lesser degree. Currently, 50 basis points is the consensus view.
Alternative investments had mixed results in October. Broad commodities, as measured by the Bloomberg Commodity Index, were up +1.67% over the period, helped by a slightly weaker dollar and rally in oil prices.
WTI Crude oil increased by +8.86% during the month to close at $86.53 per barrel. This reverses a several month decline after oil prices peaked at above $120 per barrel earlier this year. The monthly increase in prices was largely caused by OPEC+ announcing they would cut output by 2 million barrels per day. Despite this, the national average gas price finished the month at $3.76 per gallon according to AAA, slightly down from last month and much lower than the high of $5.01 seen in June.
In contrast to oil, natural gas prices continued to decline in October and now are more than 40% below their highs in late August, a welcome sign for consumers hit by high inflation in many other areas of their life. Record domestic production and warmer than usual autumn weather has led to the price decline. Forecasts for next year look lower as well due to more efficient North American drillers increasing supply and potentially slower growing demand from a weaker economy. A colder than expected winter is one big risk that could cause prices to escalate quickly.
Gold finished the month down -1.63%, bringing its YTD return to -10.70%. Gold’s disappointing returns relative to its safe haven status have been caused by rising interest rates and a strong US Dollar. However, the shiny metal has outperformed longer dated Treasuries, another classic portfolio hedge and safe haven, by a wide margin in 2022. Looking forward, Gold may be a useful portfolio diversifier and alternative to international equity exposure if the US Dollar weakens.
Hedge fund strategies had mixed results during the month, with six out of nine strategies tracked posting positive returns on average. Merger Arbitrage strategies were the top performer, up +1.98%. Merger Arbitrage strategies often provide a low, steady return and diversification benefits that complement equities and fixed income.
In October, the International Sustainability Standards Board (ISSB), of the International Financial Reporting Standards (IFRS) Foundation, announced that Reporting on Scope 3 emissions will be included as part of required company disclosures. The SEC has proposed requiring disclosure of Scope 1 (emissions that occur from sources that are controlled or owned by an organization) and Scope 2 (emissions associated with the purchase of electricity, steam, heat, or cooling) emissions, with some flexibility around Scope 3 (emissions originating in a company’s value chain and beyond its direct control) disclosures. The ISSB announcement may put some pressure on the SEC to adopt compatible requirements.
In October, the ESG integrated S&P 500 and the ESG integrated Emerging Markets exposures outperformed their non-ESG integrated counterparts. The ESG integrated EAFE index trailed its non ESG benchmark slightly. The ESG integrated corporate bond index matched the performance of its non-ESG integrated benchmark in the month. 2022 has been a difficult year for the ESG integrated indices performance in general, but the October numbers offer a moment of respite.
The ESG aligned U.S. index outperformed its non-ESG counterpart by 77 basis points in the month of October. Year-to-date the ESG exposure outperformed by 48 basis points. The one year, three year, and five year time periods all remain additive to performance compared to the non-ESG aligned benchmark, strongly supporting ESG integration within this exposure.
ESG integrated EAFE returns experienced 22 basis points of underperformance in October. Year-to-date, the performance of ESG integrated EAFE trailed its benchmark by 102 basis points. Longer time periods also demonstrate some level of underperformance, with the five year number being close to breakeven.
Emerging Markets ESG equity performance led its benchmark in October, outperforming by 50 basis points. This year has been particularly volatile in the Emerging Market category, reversing its strong track record of being accretive to performance. The year-to-date number shows 181 basis points of underperformance. All longer time horizons also currently trail the non-ESG integrated benchmarks with the five year number approaching breakeven.
ESG integrated fixed income returns were flat to its benchmark in October. Year-to-date, the performance of ESG integrated fixed income trailed its benchmark by 8 basis points. The three year and five year return numbers continue to show outperformance for ESG integrated fixed income.