Global Commentary Q3

The views expressed are those of Anchor Capital Advisors, LLC (“Anchor”) and are subject to change at any time. They are based on our proprietary research and general knowledge of said topic. The content and applicable data are in support of our views on said topic. Please see additional disclosures at the end of this publication. 

Introduction

The equity and fixed income markets continue to be volatile with the back drop of high inflation[1] and high interest rates.[2] The markets are anticipating that the Federal Reserve will make a misstep and potentially cause a recession,[3] a result of the Fed’s commitment to aggressively bringing down the stubbornly high inflation through increasing interest rates and quantitative tightening.[4] Questions remain, can companies and consumers weather this current market landscape as many entered into it, with excess cash on their balance sheets?[5] What would be the potential timing and magnitude of a recession? Through volatile markets such as these, Anchor remains focused on downside protection and defensive positioning.

 

Source: eVestment Analytics

 

U.S. Equity Markets

All U.S. equity markets ended negative for the quarter with growth indices down more than value.[6] The S&P 500 and Nasdaq are firmly in bear market territory as defined by a 20% decline in the markets.[7] Large cap stocks outperformed mid and small cap stocks.[8] The markets had a short bear market rally at the beginning of the quarter with the hardest hit stocks and sectors rebounding the most.[9] In mid-August investors started to get concerned about continued high inflation numbers and how quickly the Federal Reserve would raise rates to combat the inflation, which resulted in a sell-off in the markets in the second half of the quarter.[10]  Value sectors continue to perform well with energy and utilities as the only positive performing sectors for the year.[11]  We are also seeing other defensive parts of the market like consumer staples and health care performing well.[12]  Growth parts of the markets like technology and consumer discretionary continue to trade down.[13]

 

Second quarter earnings were generally positive for most companies.[14]  However, as the quarter progressed, we saw several companies preannounce revised down financials.[15]  Many of these companies are cyclicals and are generally seeing lower volumes and higher inflation-related costs impacting their businesses. On the flip side travel and entertainment remain strong. The airlines are reporting a rebound in business travelers and strong bookings for holidays.[16]  Concert and ticket promoters are reporting strong ticket sales for concerts and other entertainment.[17] Nonetheless, we expect to see more earnings warnings as the year progresses.  There hasn’t been a recession without a decline in S&P 500 earnings.[18]

 

Source: eVestment Analytics

 

Inflation

Inflation, as measured by the consumer price index (CPI), peaked on a year-over-year change at 9.1% in June.[19]  It declined to 8.5% annualized in July and 8.3% annualized in August.[20]  The rate of change is continuing to come down and analysts are predicting that it will decrease to 7.5% annualized by year-end.[21]

 

Energy and commodity prices have declined, but food, rent and utilities remain elevated.[22]  Many companies are facing higher inflation-related costs, which are now starting to destroy demand (volumes).  Many of these companies are saying that they can only raise prices so much before the customer balks, which appears to be happening now. We believe structural reasons, such as geopolitical events and onshoring of manufacturing and supply chains, are contributing to inflation remaining higher than we have seen in the past.

 

Fed Reserve and Interest Rates

The Fed raised interest rates five times in 2022 with the most recent 0.75% increase at the September Fed meeting.[23] The Fed Funds interest rate range is 3.0% to 3.25%.[24] Chairman Powell has stated that he will continue to raise interest rates until inflation comes down.[25] The Fed dot plot, which forecasts where interest rates are going, is predicting 4.60% on the 10-year Treasury bond.[26] As of quarter end it was 3.8%, up from 2.98% at the beginning of June.[27]

 

Many investors believed that the Fed would be forced to stop raising interest rates at the risk of putting the economy in a recession. We believe Powell wants his legacy to be his fight to control inflation. Concurrently, the Fed has been quantitatively tightening, selling $95 billion of Treasury bonds per month to pay down the Fed’s balance sheet, which peaked at close to $9 Trillion.[28] The effect is reducing the money supply and increasing interest rates, with the hopes of reducing inflation.  As a result, the 30-year mortgage rate is at 6.55%[29] and the U.S. dollar has strengthened to levels we have not seen since 2002.[30]

 

In fact, the strength of the U.S. dollar is problematic for U.S. corporations that operate abroad and need to convert profits back into U.S. dollars.  It also makes exports less competitive. Japan for the first time since 1984 had to sell U.S. dollars to buy Yen to shore up the currency since the Yen had weakened so significantly versus the U.S. dollar.[31] We believe that a weakening economy, pressures of the currency, and stress in the credit markets could force Powell to pause interest rates in 2023.

 

Oil

Oil prices have been falling steadily since June with the price per barrel going from $104 to $84 at quarter end.[32] The U.S. government has been releasing oil from the strategic petroleum reserves to help consumers.[33]  In addition, China, which is a major consumer of oil, has a decreased demand due to their Covid shutdowns and slowing economy.[34] On the other hand, natural gas prices have skyrocketed due to Russia shutting off the gas pipeline to Europe.[35] Europe has been reliant on Russia for its energy needs and is now forced to source gas from the U.S. and elsewhere.[36] In our opinion, we are seeing a shortage of oil given the underinvestment in the space and we believe that it will take time and capital to shift to renewable energy sources, which will force higher prices.

 

U.S. Economy

The U.S. economy continues to hold up well as most economic measures remain in positive territory despite slowing down.  The most notable sector of the market to see a slowdown is in housing, with the higher mortgage rates and higher prices.[37] Retail sales, outside of food and energy, were most recently negative.[38] In the positive camp, credit card sales are back to pre-pandemic levels as consumers have resumed spending on services, travel, and entertainment[39]. Furthermore, many consumers still have excess savings from the Covid time period, employment levels remain strong[40] and manufacturing indices, while slow are still in expansion mode.[41]

 

China

China’s economy has continued to slow over the course of the year with 0.4% GDP growth for the second quarter and the World Bank is forecasting 2.8% GDP growth for 2022,[42] down from the 5% GDP growth projected in June.[43]   China is facing multiple pressures, some self-imposed.   The government has had a zero Covid policy with some of the major cities shut down for weeks.[44]   This has affected consumer spending, manufacturing and export activity.[45]   China is also dealing with the highly indebted real estate market and is trying to deflate the property bubble.[46]   Finally, due to the divergence in central bank policies the Chinese currency, renminbi, has lost value relative to the US dollar, much like we have seen with other currencies.[47]  We continued to watch the Chinese government policies and the potential impact on U.S. companies.

 

Europe

Most of Europe is facing a recession or is already in one[48].  Stubbornly high inflation has put pressure on the European economies with the latest inflation readings for the Eurozone at 10% annualized[49].  Energy and food prices remain elevated due to continued geopolitical stress with Russia and natural gas supplies cut out from the continent[50]. The European Center Bank (ECB), which had kept interest rates negative since 2014, started raising interest rates in July to fight inflation.[51]  The UK is also facing high inflation, currency issues and pension problems, and had to step in to save the currency by buying Gilts[52].  We expect  to see continued stress in Europe due to the high inflation and  debt levels.

 

Anchor’s Positioning

As a value manager with a focus on downside protection, in the third quarter.[53] On the equity side, we have focused on reducing risk[54] and defensive positioning.  On the fixed income side, we have tried to keep duration on the shorter end as interest rates have moved higher. We have also increased our cash balances to manage the market volatility.  Anchor is focused on navigating these turbulent times and being ready for opportunities when the markets begin to rebound.