Endowus Q3 2022 Market Update and Outlook — Don't Fight the Fed
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Endowus Q3 2022 Market Update and Outlook — Don't Fight the Fed

28 Apr
19 Oct
  • The great unknown is not what the Fed will be doing from here or where market yields will go, but where the inflation cycle is. We need to delve deeper into what will drive inflation from here. 
  • With the value of any company in financial terms being the present value of all its future cash flows, higher interest rates make growth stocks less attractive because the cash flow from future earnings are repriced based on higher borrowing costs now. This period is also marked by risks of business slowdown, which hurt earnings that anchor how stock prices are valued. 
  • Cash is no longer trash, but it won’t beat inflation. High inflation may expose bigger, structural problems of retirement inadequacy. 

We have an inflation problem

We have an inflation problem, we know that. The Federal Reserve (Fed) will not let up on rate hikes until it is sorted, and we know that too. 

Markets have already priced this in and have moved interest rates higher meaningfully to adjust for this fact — as a result, we have had another leg down in financial markets simultaneously for both equities and fixed income in the past quarter. This time, most other asset classes have also been hammered as the concerns about slower growth or recession have risen on top of the worries about rising interest rates amid high inflation. Even commodities and gold — deemed as traditional inflation hedges — were not spared.

For investors, there has been nowhere to hide in the past quarter. 

So we know all those things and we can explain what has happened already. But what do we not know? What is not priced into the markets? This question will drive where markets will head into the last quarter of the year and into 2023. 

On 13 September, major US indices slumped the most since June 2020 as August US CPI numbers came in at a stronger-than-expected 8.3%. When the Fed Chair Jerome Powell spoke at Jackson Hole in late-August, he went as far as to mention inflation 46 times in that short speech to make his point that the Fed must tamp down inflation. This fuelled the market's violent reaction.

We have two more Fed meetings remaining this year; one on November 2, and another on December 14. According to the Fed’s own “dot plot” projections in September, it is likely to continue upping rates to 4.4% by the end of 2022. That’s a large bump from the 3.4% projection in June, and the speed at which rate hikes have been revised explains the bumpy markets we have today.

If the Fed raises rates by an additional 75 basis points (0.75%) each in the remaining two meetings this year, this will take the fed funds rate from 3-3.25% now to 4.5-4.75% by the end of the year. That would take the rates to where most (including the Fed) believes currently to be peak rates. It would also represent the biggest and fastest rate hike since the 1980s in absolute terms but an unprecedented pace of increase in relative terms. 

Chart: fed funds rate - market expectations

The markets have priced in Fed rate hikes already

The Fed still has an official mandate to target a 2% inflation goal — we know how far we are now from that number but we still don’t know for how long. The initial expectations from many market observers and even the Fed that this was a transitory situation and that inflation will eventually come down was clearly misplaced. 

The immediate future is certain. September headline CPI numbers just came in at a slightly lower 8.2% from August after peaking above 9% in June and is the lowest headline CPI since Feb 2022, seven months ago. However, worryingly, core inflation — which strips out food and energy — was up a stronger-than-expected 6.6%, reaching a 40-year high. 

The Fed’s preferred measure of inflation is the core Personal Consumption and Expenditure (PCE) price index, which is adjusted to account for consumer behaviour. In August, core PCE was up by 4.9% — more than the estimated 4.7% and unexpectedly rose after falling from its peak in Feb 2022. The PCE data will not be out until 28 October, just ahead of the Nov Fed meeting. The consensus is that the Fed will keep raising rates to above 4% and even closer to 5% to target inflation and regain its inflation-fighting credibility. In doing so, they are willing to sacrifice economic growth and even accept a recession to tame inflation. 

The markets have already moved to reflect this new reality and have taken 1-year and even the 2-year Treasury yields traded in the market up to 4.5%, reflecting two more rate hikes of 0.75% already into the market prices. The market moves ahead of the Fed’s intentions and actions. Inflation and Fed outlooks have to surprise further on the upside to have a meaningful impact on markets from there. 

Chart: Market yields priced in worst Fed hikes by year-end

The markets will learn again: Don't fight the Fed

Wall Street has been trained for decades and have learnt that it is unwise to fight the Fed. Since the previous Fed Chair, Paul Volcker, stamped out inflation and took interest rates to 20% in the 1980s, that has been the rule. 

When the Fed cuts rates, the financial markets have taken that as a sign to keep buying because you have the Fed Put — a belief that when the economy and markets are weak, the Fed will cut rates and spur it on. While we haven’t seen a protracted rate hike cycle since 2017/2018, the pace of the rate hike currently is something the markets have not experienced since the 1980s during Volcker’s time. That’s 30 years ago and most people have not experienced this in their lifetime and certainly not in their investing lifetime. If there was any doubt before, it should now have been beaten out of investors. The market is learning again to not fight the Fed.

And that remains the great unknown. With the Fed so laser focused on inflation, where is it headed? If it has already peaked and starts to come off, then the Fed by the end of the year would have completed its rate hike cycle, re-established its inflation fighting credentials, and may be in a position to ease the pace of increase dramatically or may be done with any further rate hikes. If inflation remains stubbornly high as the September CPI numbers have confirmed again and even increase further from here, then the Fed may have to take further action and take interest rates higher to 5% or even higher. This may result in further damage to the economy and certainly to financial markets. 

There is an optimistic scenario where inflation comes off faster but the economic growth slows or turns negative faster than expected and the Fed actually embarks on a rate cut cycle. So the great unknown is not what the Fed will be doing from here or where market yields will go, but where the inflation cycle is. We need to delve deeper into what will drive inflation from here. 

Chart: US Consumer Price Index (CPI) year on year changes

Economics 101: Inflation and interest rates, demand and supply

So how does this all work anyway? Why does the Fed keep raising rates to fight inflation and will they succeed? 

The interactions between inflation, interest rates and Fed policy are pretty complex. Inflation is a general, broad rise in prices for goods and services. If we use classical economic frameworks, then inflation is caused by an imbalance in demand and supply. If there is a greater demand in goods with the same supply, or demand is the same but supply falls, then the price of the goods or service will increase. So simply put, prices go up when goods are scarce or when demand is strong and vice versa — when supply is abundant and/or demand is weak we have the opposite result of prices falling. 

When the Fed raises interest rates, it also raises the cost of capital – that’s the price of money – and it is a tax on individual’s consumption as there is less disposable income. Rising interest rates lead to higher mortgage payments and potentially rent prices, less availability of credit to purchase things, and higher cost means people will consume less on goods and services. So interest rate as a tool for fighting inflation is primarily a demand controlling tool. 

If demand falls and leads to a recession and there is a sudden fall in demand, it takes time for supply to adjust and therefore prices can fall. Conversely, if demand keeps rising due to better economic outlook and rising wages then prices will steadily rise.There are different items in the Consumer Price Index (CPI) basket that have longer demand/supply cycles to play out while others will respond more quickly. Goods and services generally tend to react faster and housing and wages (employment) take longer to play out and the falls will come with a lag. 

Pie chart: US Consumer Price Index (CPI) inflation

Milton Friedman, the famous monetarist, famously quipped that inflation is everywhere and always a result of monetary phenomenon. An increase in the quantum of money (especially printed money) means that the value of that currency will fall, and you will need more to buy the same goods – resulting in an increase in the nominal currency denominated value of that good – it is true. However, it is also true to say that with a bigger quantum of money in the system from the Fed printing money, there has been excess liquidity and excess credit, which has pushed prices up. Therefore, it will take time to unwind as the Fed raises interest rates and reduces its balance sheet with quantitative tightening. 

One of the key drivers is wage inflation, which is sticky and has the biggest impact on headline inflation. But what is critical to watch also is overall demand in the economy, which has second order effects on price especially when supply is still trying to catch up to the post-Covid recovery in demand. This is why payrolls and employment numbers are so closely watched these days. 

Unfortunately, the US job report on Oct 7 showed that the US labour market remains resilient with the unemployment falling to 3.5% for September, down from 3.7% in August. (The Fed has traditionally looked at the Phillips curve that reflects the inverse relationship between inflation and unemployment, though the relation and trade-off between the two variables have been debated in recent years). 

How interest rates affect financial markets

In addition to the economic impact of higher interest rates, there is a direct impact on financial markets through earnings and valuations. Considering that the value of any company in financial terms is the present value of all its future cash flows, the higher interest rates make growth stocks less attractive because the cash flow from future earnings are repriced based on higher borrowing costs now. This normally means that despite some increase in nominal earnings, the valuation multiple compresses to reflect the higher discount rate you would need to apply on future earnings. Unfortunately, this period is also marked by risks of business slowdown, which hurt earnings that anchor how stock prices are valued. 

The only saving grace of inflation is that nominal value of sales revenue and profits will increase if other things remain equal, and hence quality companies with pricing power will be able to pass on the cost increase to clients, which means that nominally valued earnings may not fall as much as a market aggregate as people expect. 

Chart: Value vs growth - MSCI indices

‍Inflation, geopolitical risk, and recessions make for a bumpy ride

Meanwhile, the seven-month war waged by Russia’s Putin on Ukraine continues with a recent escalation that involved even the threat of using nuclear weapons, the tensions over the Taiwan straits remain high, Emerging markets are roiled by the strong US dollar and leading to crises in some and regime change in others. 

Global oil supply is being calibrated as on the one hand, both the IEA — a club of oil-importing countries – and the US, have released oil from their existing inventory to pressure prices. On the other hand. OPEC+’s latest move to cut oil production is an attempt at halting the fall in oil prices over the past several months. 

The dollar index hit a 20-year high in Q3. The rise of the US dollar, linked inextricably to the hawkish stance by the Fed and its fast pace of rate hikes creates a bigger gap in the interest rate differential with the rest of the world. A higher dollar creates scarcity of the US dollar in emerging market countries that require the dollar for trade and finances. This has traditionally led to stresses in the emerging market economies that have a current account deficit and may lead to a balance of payments crisis given the higher costs of servicing dollar-denominated debt and the pains of foreign outflows that typically follow a strong USD. 

What has recently been added to the mix is the UK market in turmoil, after the new government announced a cut to the highest tax rate (a move that the government has since U-turned on). For a time in September, the long-dated UK gilts briefly found no buyers — an unprecedented situation. The turmoil plunged UK pension funds into a liquidity crisis, forcing the Bank of England to step in. Questions still swirl on the long-term damage to the UK government debt market. 

The International Monetary Fund (IMF) sees a growing risk that the global economy will slide into a recession next year. On October 11, it cut its global growth outlook to 2.7% in 2023, from the July projection of 2.9%. It also sees a one-in-four odds of 2023 growth coming under 2%.

Goodbye TINA, there is an alternative

In the last decade or so, investors have bandied around the term “TINA”, or “there is no alternative” to justify going all-in on stocks or risk assets. That’s because the lower-for-longer rates environment had meant that other assets, especially cash, would deliver poor or negative real returns. With money pouring into stocks amid flush liquidity backed by global central banks (and led by the Fed), the US stock market charged into its longest bull run in its history, starting early-March 2009.

In 2022, the TINA tune has turned. With the Fed aggressively shifting from quantitative easing — i.e. keeping rates low in hopes of sparking business demand — to the current period of rate tightening as inflation rears its ugly head, investors can derive decent income from bonds. 

It is true that the bond market has gone through an unprecedented rout — the worst in modern history. It is, for example, the worst for the US market since 1969 (then at -8.1%), according to Vanguard’s figures that stretches all the way to 1926 (with reference to S&P’s High Grade Corporate Index from 1926 to 1968). The Bloomberg Aggregate Bond Index, as a benchmark for the investment-grade US bond market, is down about 20% year-to-date as of September 2022.

But there’s more yield to be found in bonds now, even with high-quality investment-grade bonds. Because bond prices and interest rates move in opposite directions, higher rates have led to lower prices. Bond managers then actively trade in the bond market to capture more yields from sold-off bonds. The risk here is that bond managers are caught wrong-footed and fail to price in the expected rate hikes ahead. Still, if the game is to generate income, longer term income investors are seeing an alternative beyond stocks.

Cash is not trash (but it won’t beat inflation)

The long lines at banks today reflect the rising demand for fixed deposits, with banks in Hong Kong as of early October this year offering as much as 4% p.a. — if customers lock up tens of thousands of fresh funds for at least a year. 

At the last 13 Oct auction, six-month T-Bills of that tranche offered a yield of 3.77% per annum. Still, remember that with headline inflation in September at 8.2%, and core inflation at 6.6%, holding cash alone is not a viable solution in the long term. High inflation may expose bigger, structural problems of retirement inadequacy. 

‍Global equities — still on a rollercoaster ride

Chart: global equity markets' returns - MSCI stock indices

Most of the world’s equity markets rallied in July, spurred by hopes of interest rate cuts by the Fed on concerns of a slowdown in growth. However, that soon changed. Disappointment over the Fed’s announcement to continue with the 75 basis point rate increase led to stocks sliding lower in August and continuing their downward trajectory in September. 

In the Eurozone, the European Central Bank (ECB) continued to raise rates as annual inflation for the region increased from 9.1% in August to about 10% in September. While the eurozone economy grew in the second quarter, indicators showed that the economy was likely weakening.

The emerging markets region was flat in both the first two months of the third quarter. China, one of the few countries to buck the trend, had a difficult July as incoming economic data remained lacklustre. Returns started to improve in August on the back of policy announcements but fell again in September as China maintains its zero-Covid stance.

Growth outperformed value in the third quarter. Value stocks lagged growth stocks in the first month of Q3 and even though value overtook growth in the last two months, the outperformance wasn’t enough to offset the underperformance in July.

Equities performance by returns

‍Global fixed income — no place to hide

After a brief moment in positive territory in July, fixed income asset classes continued their downward slide as interest rates and yields climbed higher. Longer duration sectors, hence, more interest-rate sensitive, performed more poorly than shorter-duration and more credit-sensitive sectors. Credit spreads widened, suggesting worsening economic conditions and increased risk.

High yield bonds generally fared better than investment grade bonds but only in relative terms as all the fixed income asset classes ended up in the red in the third quarter. EM debt, in a reversal from the previous quarter, outperformed global investment grade debt and US Treasury bonds on a relative basis.

Fixed income performance by returns

Commodities and gold — safe harbour no more

Most key commodities declined in the third quarter except for wheat. Crude oil was one of the worst performers for Q3, declining by more than 20%. Precious metals, in particular gold, had not been spared from the sell-off, having fallen close to 10% in the year-to-date period. Gold had long been designated as a safe haven by investors fleeing from the volatile stock markets but this year had shown that this thinking may be changing. Industrial metals such as zinc, aluminium and copper were also down for the quarter.

Chart: Commodities returns

There has been nowhere to hide in Q3. Yet our approach to investing is consistent — taking the long term view and sticking to your plans, investing in a discipline way in a diversified portfolio, and lower the costs as much as possible. To experience the Endowus way of investing, sign up to start your investment journey. here.


Risk Warnings

Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. 


Whilst Endowus HK Limited (“Endowus”) has tried to provide accurate and timely information, there may be inadvertent delays, omissions, technical or factual inaccuracies or typographical errors.

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