Client Letter 2022 Q3

Q3 2022 Market Results

The third quarter was another rough one for the markets.  The S&P 500 was down -4.88% and down -23.87% for the year.  The S&P 500 set a new YTD low on September 30.  International markets were down -9.33% for the quarter and down -26.96% YTD.  Emerging markets were down -11.42% and are down -26.89% YTD.  The general bond market was down -4.75% for the quarter and is down -14.61% YTD.  Short treasuries were down -1.62% for the quarter and down -4.52% YTD.

Portfolio Thoughts

Portfolios were once again down across the board in Q3-2022.  Both equities (stocks) and bonds were down across the globe.  And because of that, both aggressive and conservative portfolios were down.  None of our portfolio strategies held up particularly well, though our Tactical portfolios did slightly better mostly due to the specific tactical options included.  This continues to be a very strange, and difficult to predict market given the high inflation we are experiencing.

We had a nice rally going from the about the middle of June to the middle of August, because the inflation story seemed to be improving.  Then the August inflation was announced at 8.3%, not much below the 8.5% from July.  That sent the market down because investors are wondering, justifiably, if the Federal Reserve (Fed) raising interest will be enough to contain inflation.  And I expect this volatility to continue until that question is better answered.  We continue to believe it is too late to sell, and possibly, too early to buy.  We also feel inflation won’t be contained until the Fed raises interest rates enough to send us into recession, which we feel will happen in 2023.  We’ve moved from a 50-50 2023 recession view to 70-30.  On the plus side we are seeing some improvement in the labor market, but much slower than hoped.  We are also seeing improvements in the supply chain that is helping the economy normalize.  The bad news is that the current Cleveland Federal Reserve Bank inflation estimator is seeing inflation in September around 8.2%, barely below the August reading.  Let’s hope that turns out to be incorrect.  We still believe a rally into year-end is possible, as we expect the inflation story to improve, but our expected market recovery is now pushing into late 2023 or even 2024 due to the likely recession in 2023.  We repeat what we said last quarter, as hard as it is, we have to grit our teeth and get through this volatility.  Better days are coming.

Q3 2022 Notes

The most important economic element right now is tied to the Fed and its raising of interest rates.  The Fed raised rates by 75 bps (0.75%) at its June, July and September meetings.  The Fed is very serious about wanting to reverse inflation.  The Fed Funds rate now is 3.00%-3.25%.  And more rate hikes are coming.  That is especially true if the September inflation amount is higher than expected.  Not everyone believes these rate increases will contain inflation.  The strongest argument against the rate increases comes from economists who believe the problem here isn’t interest rates, but instead is the huge increase in the M2 money supply that occurred during the pandemic.  M2 increased, at least in part (if not in whole) because of stimulus funds voted by Congress during the pandemic.  The idea of that stimulus was to help people and businesses survive the pandemic and its effects.  Some economists argue Congress went too far and added so much M2 that inflation was almost guaranteed to happen.  We believe this argument is gaining traction because so far, the Fed’s interest rate increases have not made a substantial dent to inflation.  The good news here is that M2 has shrunk recently, suggesting economic forces are starting to normalize, but it’s a slow process for sure.

The other item in the U.S. worth mentioning is that it’s mid-term election time with everyone in the House of Representatives running and numerous Senators also running for reelection.  Polls suggest the Republicans will take back control of the House.  The Senate polls show a toss-up between the two parties for control.  If Republicans take back just one branch of Congress, we’ll essentially see an end to whatever is left of President Biden’s agenda.  We’ll see the results after the November 8^th election.

Globally, I want to come back to a topic we covered last quarter, the war in Ukraine.  Last quarter I suggested that given the fact that Russia was grinding on the Ukrainian military, and gaining territory slowly but surely, that Ukraine was going to end up in a negotiated settlement that compromised their sovereignty.  At the time last quarter, we believed this was absolutely true given the circumstances on the ground.  But, as is so often the case, things have changed.  Let’s start by talking about the military support Ukraine received after Russia’s invasion.  The U.S. led NATO countries in supplying arms to Ukraine to allow them to repel Russia.  The majority of weapons shared were mostly defensive weapons.  Especially anti-aircraft and anti-tank weapons that greatly helped Ukraine slow the Russians, but it did not stop their advance.  The U.S. did not supply Ukraine with more offensive weapons in an effort to reduce potential escalation with Russia.  The U.S., and NATO, do not want a direct conflict with Russia.  But as it started to become clear those defensive weapons could not stop Russia and the Russians continued to gain territory and all but fully absorb the eastern portion of Ukraine all the way south to Crimea.  The U.S. and NATO decided to change strategy and supply Ukraine with more offensive weapons such as rocket and missile systems that could strike Russia from extended distances.  You may have seen the HIMARS (High Mobility Artillery Rocket System) mentioned as a key element.  These systems allow Ukraine to target Russian logistics and storage areas, which has proven a game-changer in the war.  Ukraine has now taken back some territory and continues its counterattacks.  Ukraine has even been able to attack areas that are directly in Russia, much to the Russian’s dismay.  On a side note, Russia at this point has proven it isn’t even a real regional military threat, let alone a global one.  Vladimir Putin has put his country’s shortcomings on full display.  It will take Russia decades to recover from this, no matter the end result.

Now, getting back to the current situation, we believe it remains true that this is Russia’s war to lose.  They have more men, more artillery, more tanks and unlike Ukraine, Russia has actual military and war experience.  All of which suggest that Russia may very well re-group and once again start overtaking Ukraine’s forces.  Some of this will be determined by how much more the U.S. and NATO countries will be willing to do, and how much more military equipment they will provide.  There’s no doubt this is getting expensive, and some countries have already started balking at throwing money into Ukraine.  It will be interesting to see how this continues to play out.  As we pointed out last quarter, the U.S. won’t tolerate Russia taking over Ukraine and being directly on the border with Poland.  But a partial territorial settlement to end the war might be a reasonable compromise from the U.S. view.

As always, we will watch and research the global economy and make investment choices to the best of our ability for each and every client portfolio.  If you have questions about your portfolio, our views expressed in this letter, or anything else financial, please do not hesitate to call.

Best Regards,

Jim