The Essence of Elasticity

Market Commentary | Q3 2022

When a coiled spring is subjected to a temporary force, such as being stretched or squashed, its shape gets distorted. During this process, energy builds up and the further it is distorted the greater the amount of energy. Once the temporary force is removed, the energy is ultimately released as the object returns towards its original shape. In physics, this is referred to as elastic energy, which falls under the broader umbrella of “potential energy.” The essence of elasticity is reversibility. While financial markets don’t behave in such simplified ways, the same concept can be helpful to consider during periods of dramatic price appreciation or decline.
 
Portfolio values were stretched in 2020 and 2021, with markets pushed higher by near-zero interest rates and pandemic recovery hopes. In 2022, markets are instead feeling the strains of soaring inflation, climbing interest rates, and concerns about slowing growth, bringing values back down. When we zoom out, we can see that the forces exerting this downward pressure are temporary, but the discomfort is very real in the short term.

One Step Forward, Two Steps Back

After two difficult quarters to start the year, the third quarter started with optimism surrounding a resilient corporate earnings outlook, a potential peak in inflation, and hopes that the current Fed rate hiking cycle would end sooner than expected. Gains were ultimately short-lived. Throughout August and September that optimism was eroded by stubborn inflation data and a Federal Reserve that made clear its intentions to continue pushing rates higher.
 
Overall, the S&P 500 fell by -4.9% over the quarter and international stocks, measured by the EAFE index, declined by -9.4%. Meanwhile, under pressure of rising rates, US bonds also fell by -4.8%.
 
Investors vacillated in their interpretations of economic data over the course of the quarter. After all, bad news can be good news for investors in that signs of a weaker economy mean lower inflation, which means less monetary policy tightening, which means lower interest rates, which means higher stock valuations. That series of mental gymnastics was on full display at various points in the quarter.
 
In August, the uncertainty was replaced with clarity when the Fed reiterated that its priority remains the fight against inflation rather than supporting growth. This was the primary driver of the sell-off in stock and bond markets in the second half of the quarter. Central banks backed up their tough talk with policy rate hikes totaling 1.5% from the Fed, 1.25% from the European Central Bank, and 1.0% from the Bank of England. Investors started pricing in a more aggressive path of future rate hikes, with rates now expected to reach 4.5%, 3.5%, and 5.75% by next year in the US, Europe, and the UK, respectively. These moves have together had the effect of slowing down economic activity globally.
 
Annual returns are negative across all major asset classes as we enter the fourth quarter, and this is now the 9th time the S&P 500 has declined by 25% or more since 1950. In each of those prior instances, patient investors saw prices recover and reach new highs. The current environment does not have the same level of panic as we saw in 2008 or other historical declines, but nonetheless, it is a difficult part of the economic cycle to live through.

Potential Energy

Returning to our coiled spring analogy, the upside is that the same forces of elastic energy work in reverse. After the quarter closed at new lows, the S&P 500 jumped by 2.6% and 3.1% on the first two days of the new quarter. The 5.7% combined surge is the index’s largest two-day gain since April 2020, when stocks were in the early innings of the rebound from the Covid-19 bear market low and the best two-day start to a quarter in history. This doesn’t mean the recovery rally has begun – rather that investors are still oscillating in their perspective about how the inflation battle will progress over the upcoming months.
 
Some data shows that inflation is already slowing. The WTI (West Texas Intermediate) oil price dropped by 25% during the quarter, while the UN’s FAO Food Price Index dropped to its lowest level since the start of the war in Ukraine.1 Additionally, trans-Pacific shipping rates have plummeted roughly 75% from year-ago levels as big retailers cancel orders with vendors and step-up efforts to cut inventories. Daily freight rates now average $3,900 to move a single container across the Pacific, compared with $14,500 at the start of the year and more than $19,000 in 2021, according to the Freightos Baltic Index.2
 
Looking at different data can paint a more resilient picture of economic activity, which renews concerns about continued aggressive policy from the Fed. Despite a few notable earnings misses from major companies, the aggregate Q3 earnings for the S&P 500 are expected to rise 2.9% from a year ago.3 The September jobs report, which came in above estimates, showed that employers are still hiring. The US unemployment rate stayed generally flat during the quarter at 3.5%, remaining at historically low levels.
 
Any reduction in geopolitical tensions between Russia and Ukraine would likely also provide a boost for global risk assets, including US stocks and bonds. There is no evidence that a resolution is imminent, but the market will react positively when the current spectre of uncertainty, destruction, and disruption is alleviated. This is another form of potential energy that has yet to be released into prices.

Looking Forward

As we enter the fourth quarter, the global economy is poised for continued slowing. Many stocks are already pricing in a relatively high probability of a moderate recession and bonds prices already reflect a significant amount of further tightening. We do not believe the risks facing both stocks and bonds have disappeared, but valuations are beginning to look more attractive for both. Many quality companies are quickly approaching pre-pandemic valuation levels, while the S&P 500 is trading at a valuation that has, historically speaking, been attractive over the longer term.
 
We work with clients to ensure they have the right amount of liquidity to navigate their lives, which allows the long-term portfolio to stay invested while awaiting the next phase of the cycle. History offers no guarantees for the future nor a specific timeline, but we find comfort in knowing that investors who maintain their long-term strategy have consistently been rewarded with positive outcomes.

Resources

1 Food and Agriculture Organization of the United Nation – Food Price Index FAO

2 Cargo Shipowners Cancel Sailings as Global Trade Flips From Backlogs to Empty Containers WSJ

3 9/30/2022 Earnings Insights  FactSet

Brian Kozel, CFP 

About Brian Kozel, CFP®

Brian Kozel is a Partner at North Berkeley Wealth Management. Brian helps clients feel confident as they navigate their financial journey.

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This commentary on this website reflects the personal opinions, viewpoints, and analyses of the North Berkeley Wealth Management (“North Berkeley”) employees providing such comments, and should not be regarded as a description of advisory services provided by North Berkeley or performance returns of any North Berkeley client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. North Berkeley manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

By |2022-10-21T13:32:00-07:00October 7th, 2022|