And just like that, it's the 4th quarter, and time for the October edition of "Adding Alpha."
We just finished three straight quarters of negative market returns,
and we haven't had this dynamic in play since 2008. Before that was 2002,
and before that was 2001. So to have this dynamic occur outside of a recessionary environment is, let's just say, #unprecedented.
And bonds have never been down three quarters in a row. It's just been an absolutely brutal year for investors.
As of this recording, the S&P 500 is down about 22% year to date and the forward P/E has fallen a little more than 6 multiple points since the beginning of the year; from about 21 and one 1/2 times to about 15 times.
We're now back to late March 2020 valuation levels.
Recent economic indicators suggest that economic growth is still holding up better than widely expected.
When we look at data like durable goods orders, consumer confidence, new home sales, and even initial jobless claims, they're all hanging in there despite some of the challenges that continue to swirl
in the backdrop.
At the same time, this means that inflation is likely to be worse than expected, meaning it's not going to come down fast enough to justify a fed pause. It's really a good news is bad news market dynamic in that inflation
will likely remain elevated though we believe we're well past the peak and that the fed will need to continue to aggressively raise interest rates into a hard landing for the U.S. economy in 2023.
As we've continued to say all year long, what matters most for markets is what happens to the expected terminal rate. The terminal rate is now sitting at about 4.6%, which is almost 100 basis points higher than the July fed meeting.
The previous terminal rate of 3.75 felt manageable both from a valuation perspective and from a historical perspective; 3.75 was substantially below normalized levels from past cycles.
In the 30 years leading up to the financial crisis, the fed funds rate averaged
about 6.6%. Since 2007, it's averaged just 77 basis points, so based on that, the odds of a soft landing actually felt pretty good.
At 4.6%, that is far into restrictive territory for markets and the economy
and financial conditions which leads us to believe the odds of a hard landing have gone up a lot and in very short order.
There's never been a scenario where the fed hiked rates to 4.6% and avoided a recession. But the final destination for fed policy is not at all a no-brainer, policy is still very much data dependent, which in our view leaves the door open as recession is not necessarily a foregone conclusion.
Let's hope this is the fed finally getting really aggressive with an underutilized policy tool in its tool kit, aka forward guidance, putting a bold and decisive outer bound out there for investors to grapple with.
At the end of the day, we can talk about the strength of the underlying fundamentals, how credit spreads remain fairly well behaved,
how default cycles have not materially picked up across asset class categories, how sentiment has improved a lot just in the last few months,
how the U.S. consumer continues to weather this perfect stream,
and even how corporate balance sheets are rock solid relative to this late stage and prior schools. But the market only cares about two things;
confirmation that inflation has peaked and/or is rolling over, and that the fed has completed its tightening of financial conditions or at least has confirmed the end state for monetary policy.
In the absence of confirmation on both of these variables, we think the high volatility regime will continue to dominate and things stay pretty choppy into year end.