The U.S. equities markets closed the third quarter at the lows for the year. With all the major equity indexes down over 20% from their peak, we are officially in a bear market.
Fixed income, on a risk-adjusted basis, performed worse than stocks. The 30-year Treasury has lost nearly a third of its value thus far this year. The benchmark Bloomberg Aggregate bond index is down roughly 15% on the year. Market historians believe 2022 to be one of the worst years on record for bond investors, and of course, the year isn’t over yet.
The selloff in stocks and bonds has been prompted by rising interest rates. Having provided massively more liquidity during the pandemic than proved necessary, the Federal Reserve is now dealing with the forty-year high inflation rates their policies created. The Fed’s goal is to reduce inflation to its 2% target without causing a recession. Fed Chairman Jerome Powell has vowed to continue raising rates as high as necessary to achieve their inflation objective.
Year-over-year interest rate comparisons are striking. The two-year Treasury note yield has risen over the past twelve months from 0.28% to 4.28%. Thirty-year mortgage rates have more than doubled from 3% to 6.5%. The magnitude of these moves in such a short period of time is virtually unprecedented, and the Federal Reserve believes continued rate hikes are merited by the stubbornly high level of inflation.
The sharp increase in interest rates has also impacted global currencies. The dollar has strengthened to a decade-long high when measured against a basket of foreign currencies. The strong dollar will hurt the reported revenues and profits of major U.S. multinational companies. Other factors that could negatively impact operating profits are continued global supply chain issues, the surge in energy costs, rising interest expenses, the ongoing war in Ukraine, and continued tight labor markets.
All of these uncertainties have increased equity market volatility to levels not seen since the global financial crisis. Now, as then, we are trying to err on the side of caution and focusing our research on companies and industries that generate positive cash flows and have clean balance sheets. As we learned in the financial crisis, high-quality businesses with manageable levels of debt tend to recover faster from the kind of broad-based selloff we are currently experiencing.
While investor sentiment remains quite negative, there are positive aspects to rising interest rates. First, retirees and others living on a fixed level of income can now earn substantially more on their cash than has been the case over the past decade. Second, fixed-income yields have increased to levels where valuations and expected returns are much more competitive relative to stocks than they’ve been for quite some time. While we still favor equities over the long term for the growth of capital and income, investors with sizable fixed-income allocations will see a healthy increase in overall portfolio income in the year ahead.
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