While it may seem like a faint memory, Q3 2022 began on a somewhat optimistic note. Inflation drivers – especially oil & food commodity prices – appeared to have peaked and there was hope that inflation would moderate quickly, appeasing central banks and avoiding a recession. Q2 earnings across developed markets were lower than the previous year but still strong – making the case for a soft landing and providing hope that markets might look through the economic slowdown. This prevailing view from July through mid-August created a short-lived bear market rally for equity and credit markets. However, in late August, the US Federal Reserve (The Fed) and other central banks reiterated at their Jackson Hole summit that their priority remains the fight against inflation rather than supporting growth and they backed up this tough talk with steep interest hikes in September. This brought into sharp focus the end of the Great Moderation – and the new regime of heightened economic and market volatility we outlined in our Midyear Outlook. Markets are grappling with the worsening trade-off policymakers face between growth and inflation.
For both stock and bond investors, Q3 probably felt like a broken record stuck on a terrible song. Across developed markets, Bond investors faced similar challenges in the quarter. Interest rates across the yield curve have risen both directly as the Fed raised the Fed Funds rate, and indirectly through the Fed’s strong rhetoric against inflation. The rate increases sent shock waves through the bond and equity markets at the same time, roiling balanced investors, who are used to some measure of downside protection from their bond portfolio in down markets. The US ten-year Treasury bond yield briefly went over 4% before closing the quarter at 3.83%. The effects of these dramatic hikes in interest rates will affect housing, the consumer, and the global economy broadly in Q4 and beyond.
The only place to really take cover this quarter and for the year has been the dollar as not only are US interest rates rising domestically, but also relative to the rest of the world. This resulted in a strengthening dollar, which jolted non-US markets as a majority of global currencies hit multi-decade lows vs. the dollar as the US Dollar Index has so far gained 17.2% Year-to-Date marking its best annual gain on record. The historic strength of the greenback has been a wrecking ball for other currencies with the Japanese Yen declining a record 25.8%, while the Euro and British pound have declined 13.4% and 17.5%, respectively Year-To-Date. The sharp rise in the global reserve currency increases debt servicing costs and trade for foreigners and is a significant headwind for global economic activity. Europe faces additional challenges with the annexation of Ukrainian territory by Russia and the stoppage of the Nord Stream Pipeline – the primary supply of natural gas from Russia to Europe. This will prove a challenge to their fight against inflation in the 4th quarter.
From a return’s perspective, the Q3 seemed to largely be a continuation of challenges of the previous two quarters. Two of the assets most commonly used to hedge equities – bonds and gold – both performed poorly as rising rates have harmed bonds at the same time as stocks in our view. The shifting perception of the Fed as an inflation fighter and the lack of any yield has also weighed on gold. While cash appears to be a haven, that is somewhat illusory against increasing inflation. In the long run, the loss of purchasing power is an important risk to guard against, since lost purchasing power can often be permanent, while stock market losses are often temporary.
United States
All four major stock indices posted negative returns for the third consecutive quarter, although unlike the first two quarters of 2022, the tech-heavy Nasdaq did not badly lag other indices and the quarterly declines were fairly uniform across the most widely followed U.S. equity indexes.
Small-cap & growth stocks outperformed large-cap & value stocks for the first time this year, although the performance gap was modest. The outperformance came mostly from gains early in the third quarter as markets broadly rallied on hopes of a quick decline in inflation and a sooner-than-expected Fed pivot. But as those hopes faded in late August and September and interest rates hit new highs, investors rotated back to the perceived safety of large-cap & value stocks, diminishing the performance gap significantly.
Consumer discretionary was the only sector in the S&P 500 to post a positive return thanks to strong consumer spending and still-low unemployment. The energy sector, meanwhile, finished the quarter with a fractional loss as energy stocks benefitted from solid earnings and strength in natural gas prices although it remains the only sector in the green year-to-date. More broadly, traditionally defensive sectors relatively outperformed over the past three months, as investors positioned for slower future economic growth.
Even though the US economy has already recorded two consecutive quarters of negative economic growth this year and the university of Michigan’s consumer confidence survey has dropped close to its lowest levels in 50 years, most economic data published in the third quarter continued to highlight the resilience of the US economy. This resilience is particularly true for the US labor market, with the latest reports showing plenty of momentum in the jobs market as the tight labor market is also generating substantial household income gains, with wage and salary income rising. While on the inflation front, consumer prices were flat in July and rose just 0.1% in August, with the year-over-year inflation rate falling to 8.2%. Markets nevertheless reacted badly to August’s consumer price index (CPI) print, as the modest 0.1% increase for the month was almost entirely explained by a 10.5% decline in gasoline prices, while there were plenty of hotspots elsewhere. That said, the Fed’s tighter monetary policy is already cooling down some parts of the economy, such as the housing market, as 30-year fixed mortgage rates have risen to well above 6%, their highest level since 2007.
Eurozone
In Europe, the energy crisis continued to dominate the headlines as Russia completely halted gas flows through the key Nord Stream 1 pipeline at the start of September. However, what had been considered the worst-case scenario for Europe didn’t lead to new highs in gas prices, which after having reached more than EUR 300 per megawatt hour in August dropped back to around EUR 200 by the end of the quarter.
The decline in European gas prices from their peaks can be explained by several factors, such as above-average imports of liquefied natural gas, which has helped the European Union (EU) to meet its target of filling 85% of the total underground gas storage capacity ahead of the coming winter. Measures proposed by the European Commission could also help to ease tensions somewhat. The near-term EU proposals focus on three main areas: a plan for EU-wide electricity savings, with a broad target of 10% for general consumption; an EU-level uniform cap on energy prices; and a tax on the revenues of fossil fuels producers. On the economic front, the situation continued to deteriorate during the third quarter, to the extent that a recession now looks like the base case. Most economic data published in the quarter pointed to a slowdown, such as the euro area composite PMI business survey, which is now in contractionary territory. Industrial production dropped sharply in July and euro area consumer confidence dropped to a new all-time low in September. While growth is decelerating in Europe, this is not yet the case for inflation, which has reached 10.1% year on year in September and is expected to remain in double digit figures for the coming months. In this context, the European Central Bank has become unprecedently hawkish, hiking its policy rate by 0.75% in September, and it is now expected to increase rates by another 0.75% in October and by 0.5% in December, to bring them to 2% by year end.
In the UK, the death of Queen Elizabeth II, the country’s longest serving monarch, dominated much of the headlines over the quarter. However, on the economic front, The UK has been at the epicenter of the trade-off that policymakers have to currently make between fighting inflation and supporting growth with the government’s fiscal splurge sparking a rout in domestic assets that forced the Bank of England to intervene and stabilize bond markets. Most data released in the quarter illustrated the loss of momentum in the UK economy. Consumer confidence fell to an all-time low in September and the PMI business survey dropped further into contractionary territory. The labor market remained a bright spot as the unemployment rate fell to 3.6% during the quarter, its lowest level since 1974. However, on the back of the extreme tightness of the UK’s job market, private sector wage gains surprised to the upside again, with the annual growth rate now running at 5.5%.
Inflation remained elevated in the UK last quarter and even though the headline CPI slightly decreased from 10.1% to 9.9% year on year, core CPI increased from 6.2% to 6.3% year on year. With a further increase expected in October on the back of higher energy bills, the Bank of England announced two 0.5% rate hikes over the quarter. However, it was the UK’s fiscal policy that attracted all the market attention towards the end of the quarter with the heightened volatility spreading across global markets. This came about as the new government announced a substantial unfunded fiscal package that would have significantly increased government borrowing which caused a significant fall-out with numerous commentators including the IMF and the US government criticizing both the new chancellor Kwasi Kwarteng and the approach of the new prime minister. UK borrowing costs rose so rapidly following the announcement of the fiscal package that the Bank of England was forced to intervene to purchase long-dated government bonds towards the end of September. Nevertheless, UK 10-year Gilt yields still ended September at 4% compared with 2.2% at the start of the quarter.
Asia
As has been the case over the last year, The Chinese economy was confronted with several headwinds in the quarter, such as the continued country’s zero Covid policy, weather-related disruptions and lingering weakness in the housing market. However, while at the start of the quarter most economic data remained weak, the data started to improve throughout the quarter on the back of policy measures which supported fixed asset investment and industrial production. However, China’s economy remains fragile, as illustrated by weak credit demand. Weak domestic demand implies that China is not facing the inflation pressures faced by most other countries. Both CPI and producer price index (PPI) inflation came in below expectations in August, dropping to 2.5% and 2.3% year on year, respectively. This benign inflation environment allowed the People’s Bank of China (PBoC) to buck the trend of other central banks around the world with a surprise decision to ease monetary policy slightly by lowering its policy rate (the one-year medium-term lending facility rate) by 0.1% to 2.75%, and the one-year and five-year loan prime rates by 0.05% and 0.15% respectively. In addition, China’s State Council, chaired by Premier Li Keqiang, announced new measures worth 1 trillion yuan, to support the economy.
The Japanese yen has already lost more than 20% of its value this year to reach a 24-year low at 145.90 in September. While it found brief respite after the Bank of Japan (BOJ) purportedly made rare checks on market levels over the last 2 weeks of the quarter, which is seen as a precursor to possible direct intervention, most market participants expect the slide will continue. Analysts are currently estimating that the yen could soon hit a 32-year low of 150 per dollar or beyond as the BOJ stays isolated in its uber-dovish policy stance while its global peers aggressively hike rates to rein in inflation.
The Yen may continue to underperform its US counterpart as the BoJ in September voted unanimously to maintain the Quantitative and Qualitative Easing program with Yield-Curve Control. The BoJ appears in no rush to switch gears as Japan’s economy is “expected to be under downward pressure stemming from a rise in commodity prices.” Governor Haruhiko Kuroda and Co. appear ready to stick to their easing cycle over the coming months. The central bank pledges to increase the monetary base until the year-on-year rate of increase in the observed CPI exceeds 2 percent and stays above the target in a stable manner.
Such a dynamic is destined to keep the yen falling, and the fact that it is “super-undervalued” already on many metrics means nothing until the BOJ shifts policy, said Tohru Sasaki, head of Japan markets research at JP Morgan Securities in Tokyo. “We’re riding in a car down a slope with broken brakes…unless we fix the brakes, it will just keep going down,” Sasaki said. “There is no reason to think the yen will stop at 145 or 150 as long as all the fundamental factors remain the same.”
Commodities
Key commodities dropped sharply during the third quarter, as a combination of a multi-decade high in the U.S. dollar, growing fears of a global recession, and sharply rising real interest rates weighed on industrial commodities as well as traditional safe havens like precious metals. The notable exception were wheat prices, which rose 4.24% for the period, as the world’s wheat supply remains affected by Russia’s aggression in Ukraine. Despite Gold’s long history as a safe haven, its ability to improve portfolio performance during these turbulent times has been unconvincing. This quarter, the asset class sputtered and fell into negative territory with losses of 8.10%.
Copper also ended the third quarter in the red, though its decline was muted compared with the steep second-quarter drop of 21%. The metal is seen as a bellwether for the global economy, as it is used as an input in production and equipment for a wide range of industries. Equally, Oil prices fell in the quarter (WTI slumped 24.84% while Brent Crude dropped 21.87%) as concerns about a possible incoming recession affecting future demand offset geopolitically based worries about supply.
Local Market
The Nairobi Stock Exchange gained 3.2% in the third quarter of 2022, driven by double-digit gains posted in July (+13.3%). The NASI however, pared gains in August and September in-line with other global markets. The NSE 20 index posted the highest gain among benchmark indices, up 6.5% quarter-on-quarter (q/q); the price-weighted index presented a more stable performance in the three months. Compared to other key African markets, the NSE provided positive USD returns of 0.5% in the quarter, partly battered by the strengthening Dollar.
Turnover stood at USD 186.2m, lower 15.5%q/q as trading activity slowed in the month of August during the country’s Presidential general elections. Four stocks accounted for 83.5% of trading activity, led by Safaricom; the others were Equity Group, KCB and EABL. Of the top ten movers, seven closed higher, recouping losses from the second quarter. However, most are still trading lower YTD. Foreign investors remained bearish but net outflows shrank 37.7%q/q as participation fell to 34.2%, possibly owing to global interest rate hikes and a wait-and-see attitude during the election period.
Q4 Outlook
As we start the final quarter of 2022, an honest assessment of the macroeconomic landscape reveals that the markets and the economy are still facing numerous challenges from still-high inflation, ongoing Fed rate hikes, and geopolitical instability. With all of this in the back of our minds, the global economy should continue to show signs of deceleration while some economies could enter recession. The magnitude of this potential recession will partly depend on the effectiveness of measures deployed by policymakers to reduce the impact of the energy crisis on households and businesses. Central banks, confronted with the biggest inflation shock since the 1970s, will for their part very likely continue to prioritize the fight against inflation over supporting growth.
The markets appear to be at a significant inflection point heading into Q4. Long rates are coming off their biggest monthly gain in 2022, suggesting there is further upside as prices (yields) often peak after momentum or rate of change. Bond prices, in aggregate, are falling multiples of prior record declines, raising concerns that could result in negative unintended consequences in the plumbing of the financial system. Equity benchmarks are just beginning to make fresh lows previously established three months earlier in June. While earnings multiples have compressed sharply, we have not yet seen the effect of significant earnings estimate revisions, though this could be a factor as earnings season begins.
Elevated inflation, the sharp rise in global rates, and the strengthening greenback have been significant headwinds to the rest of the globe, which recently has led to central bank intervention in local FX and treasury markets. The Federal Reserve is only a few weeks into its elevated level of QT as the government balance sheet remains close to $9T. Markets are expecting another 125 bps in rate hikes over the final two FOMC meetings in 2022, with the lagging economic impact of prior hikes still to come.
So, while the outlook for risk assets remains challenged, that reality must be considered in the context of a market that has declined substantially and, presumably, already priced in a lot of “bad news.” Valuations on many quality companies are quickly approaching pre-pandemic levels, while the S&P 500 more broadly is trading at a valuation that has, historically speaking, been attractive over the longer term. Additionally, multiple sentiment indicators have hit or are approaching levels that historically have represented extreme pessimism and bearishness, and they are largely ignoring the reality that there has been some improvement in the macroeconomic outlook over the past several months.
Although geopolitical tensions remain very elevated as Russia has recently escalated the war in Ukraine and the risk of a broader conflict simply can’t be ruled out, most Western countries remain united in their opposition to the Russian invasion of Ukraine and that will continue to be a powerful deterrent to Russian President Putin. Furthermore, even some of Russia’s most important allies, including China and India, have voiced concerns about the escalation of the war over the past month which has further isolated Russia from the global community. Any reduction in geopolitical tensions would provide a surprise boost for global risk assets, including Stocks and bonds.
Overall, while the growth outlook remains challenging, stock markets are now already pricing in a relatively high probability of at least a moderate recession. Government bonds are now also pricing in a significant amount of further tightening. So, after a very difficult year so far for both stocks and bonds, long term valuations now look more attractive for both. It is therefore helpful for investors to remind themselves of long-term goals. Investing can essentially be broken down into two very broad objectives. The first is wealth accumulation, investors building wealth toward long-term goals such as retirement. A prolonged bear market is an investors best friend in the long run as it allows us as market participants to buy slowly and consistently into bear markets to create long term returns. The second is risk management to create a sequence of returns that is as smooth as possible. For this second objective, we remain adamant in our belief that continuously incorporating hedging strategies to improve risk management is imperative for the preservation of capital for our investors especially during these turbulent times.
This article was written by the Global Markets Division of Standard Investment Bank. For inquiries, please contact us via clientservices@sib.co.ke