Key takeaways

• Markets whipsawed violently during the quarter, taking investors on a wild ride. 
• Stagflation is here, setting the stage for unpleasant policy trade-offs and continued volatility. 
• Anxiety remains high as recession risks rise, but cheaper markets offer better compensation than earlier this year. 

The third quarter left investors shell-shocked, with high volatility and waning optimism

Buyers conditioned to “buy the dip” received a wake-up call as risk repricing continued. Anxiety remains high as the trade-offs faced by policymakers become clear, and a lack of capitulation means volatility may continue. As investors begin to price in a new, higher rate regime, cheaper valuations offer better compensation than earlier this year.  

After entering a bear market in June, risk assets recovered in July. However, by quarter end, most asset classes closed in a sea of red, at or near new lows. For the third quarter in a row, bonds delivered equity-like risk, nearly matching declines in major stock indices. Investors’ hopes for some offsetting effect from fixed income were dashed. The YTD total return on long treasuries (Bloomberg Barclays US Long Treasury Total Return Index) exceeded the decline in the S&P 500 as the two markets remained in sync. Most of the yield curve ended the quarter around 4%, a stark contrast to the beginning of the year when the positively sloped curve peaked at under 2%. Supported by a higher US rate regime, the dollar strengthened, pressuring corporate earnings and the global economy. Despite slower growth and interest rate volatility, the riskiest credits held on to some of their improvement over the prior period.

Stagflation is here as red-hot inflation refused to yield to negative real GDP growth in the first half of the year. Despite a contraction driven by inventory swings, pundits are terming the situation a “technical recession” as a resilient jobs market and higher real demand reflected conditions too strong to meet the conventional definition. For now, the labor market remains robust with an unemployment rate of only 3.5% in September despite slowing growth. Inflation continues to run too hot with broad measures like the Federal Reserve Bank of Cleveland 16% Trimmed Mean Consumer Price Index (CPI) yet to roll over with an increase of over 7% year-over-year in August. 

Stagflation makes for unpleasant trade-offs as policymakers turn the screws into an uncomfortably slow economy. At the beginning of the year, policymakers expected inflation to fall on its own as pandemic effects burned off.  Instead, inflation has broadened, and wage growth has picked up. The Federal Reserve (Fed) has been wrong and is now focused on defending its credibility. Policymakers are all-in, prosecuting the biggest increase in rates since the late 70s despite the risk of an overshoot. While it’s likely that inflation has peaked (or will shortly), the big question is where it will settle. Companies will try and defend margins, testing pricing power as they play catch up. Labor still has leverage and is demanding higher wages to maintain living standards. So far, job-hoppers have been rewarded when current employers haven’t stepped up. If wage gains continue to exceed productivity improvements, the pressure on the Fed remains high. Unfortunately, reducing labor’s clout through higher unemployment is a feature, not a bug, highlighting the difficulty in the goal of balancing both inflation and employment targets.

The Fed was forced to reset expectations

The odds of a recession are rising quickly as the Fed continues to tighten against a backdrop of what appears to be an inevitable slowdown. The Fed’s balance sheet reduction (Quantitative Tightening or QT), projected at $95 billion/month over the next 2-3 years, is just getting started and will exacerbate tighter liquidity. Consumers are relying on savings to prop up consumption as inflation erodes spending power, a trend that can’t go on forever. Higher mortgage rates are an immediate headwind for the housing market which is slowing rapidly. There are signs that corporations are becoming more cautious as inventories outstripped demand in some sectors. Geopolitical risk is sky-high as war, commodity shortages, and civil unrest add to global uncertainty. 

Leading indicators flash a warning

Monetary policy works on a lag of 12-18 months, forcing decision-making in a fog of uncertainty

While monetary authorities can see signs of an impending slow-down, the fear of unanchored inflation expectations and a wage-price spiral is driving action. A soft landing is still possible, but the needed slowdown is unlikely to happen without higher unemployment and pressure on earnings, making it a high-risk maneuver.

This cycle is unique, and the current environment is underpinned by significant risks. This is the first time in decades that policymakers are facing persistent inflation. Monetary policy is ill-suited to address supply shortages, and fiscal relief is constrained by high public debt and the worry that help might spur demand. The slow grind towards higher wealth and income inequality over the last decade will keep the heat on policymakers who need to balance goals that seem at increasing odds. While market action was shaky at the end of the quarter, it doesn’t seem like we’ve seen the indiscriminate selling that’s the hallmark of capitulation. Investors would be wise to balance investment decisions with liquidity and holding period constraints when bargain hunting in what’s likely to be a volatile environment.