The third quarter of 2022 saw equities officially enter a bear market amidst declining global economic sentiment.  Persistently high inflation has led the Federal Reserve to embark on an aggressive course of rate hikes, while price shocks continue to ripple from the conflict in Ukraine and Covid containment policies in China.  The combination of tightening financial conditions and higher-than-anticipated inflation readouts set the scene for the S&P 500 to suffer its third-worst annual performance through Q3 since the 1950s.

Since March, the Federal Reserve has raised the Fed Funds rate by 3%, or 300 basis points.  The market is still pricing in another 125 bps in hikes by year-end, for a total 2022 hike of 425 bps.  This stands in stark contrast to the 75 bps expected for 2022 back on January 1st. Fed chair Jerome Powell sent an explicit message to the markets with his August speech at the Jackson Hole summit, where he stressed that the Fed is dedicated to bringing inflation back down to its 2% goal.  Hopes for a swift return to a more accommodative policy were dashed by his comments, which when taken in conjunction with August’s hot inflation number (August core CPI inflation was 6.3%, against 5.9% in July) and the tight labor market (the unemployment rate is at a historically low 3.7%) indicate that the Fed is willing to cause a recession if it is needed to contain inflation.

The U.S. dollar continues to strengthen as the Fed hikes, with the dollar index up 17.2% year-to-date.  This is the most rapid appreciation in the reserve currency since 1967, leading to negative effects for foreign market participants.  Dollar-denominated debt has become far more expensive to service, and American exports are becoming less competitive.  While the U.S. does benefit from greater purchasing power abroad, global economic activity will further suffer if the dollar remains this strong.  Domestic companies doing business abroad have already seen significant impacts on their earnings from foreign exchange rates.

2022 has been one of the worst years on record to own financial assets.  Pessimism abounds in the headlines.  The market’s performance is intimately connected to consensus expectations – the plummeting prices represent diminished forecasts, meaning the market has already “priced in” a great deal of future negativity.

Despite all the doom and gloom, the U.S. economy has been a bastion of strength.  Domestic earnings have held up relative to the collapse in valuation multiples.  Hopes for lower inflation drove the fleeting rallies in July and August, but the final weeks of September saw concrete indications of improving conditions.  If inflation continues to moderate, the Fed’s rate hikes will have been successful, and asset prices have the potential to rebound at the first sign of easier monetary policy.

In such a pessimistic time for the market, it pays to remember the importance of buying low.  Opportunities to buy quality businesses at cheap valuations abound.  History would suggest that these opportunities do not last forever – optimism will eventually return, and when it does, asset prices will move higher.