The LTWM Insider – Market and Economic Commentary Q3 2022

Executive Summary 

Three challenging quarters for investment portfolios, both stocks and bonds were down together again at the end of the third quarter. We are in a bottoming process that won’t likely end until the Federal Reserve Board (the Fed) pauses from its rate hikes and/or its bond selling. The Fed has delivered strong actions, two 75 basis points (bps), or 0.75%, rate hikes during the quarter to slow the economy in its attempt to bring down inflation. The overnight lending rate has moved from 0% in the first quarter to 3.25% currently and another 125 bps, 1.25%, of rate hikes are expected between the two remaining meetings in November and December this year. The Fed started its $8.9 trillion balance sheet reduction (selling bonds) and has ramped up to a rate of $95 billion per month in September or $1.1 trillion annually. The massive bond selling has created low liquidity and high volatility in the bond and stock markets.

The concern is the Fed is risking a hard landing for the economy as it attempts to bring inflation down quickly per its mandate. Higher mortgage rates have successfully slowed a frothy housing market, which was very much needed to keep housing and rent affordable. Commodity prices ended the quarter down 18% from their highs in June, but there are many contributing factors reducing the supply of energy around the globe and the price of crude and natural gas remains elevated.

The last S&P 500 peak was on January 5th, we are about 278 days into the current correction, which includes stocks, bonds, real estate, bitcoin, and gold. The asset classes and stocks with the highest valuations are down the most, value stocks are down the least, which has helped LTWM portfolios because we have a sizeable value bias. Markets are experiencing an outlier event, bonds have never in history been down so much at the same time as stocks. A deeper look at historical returns during recessions reveals another interesting insight, if we divide recessionary and expansionary periods in half and present average monthly returns over these subperiods, U.S. stocks have enjoyed strongly positive returns in the second half of recessions and small value stocks have higher positive returns (see research article from Avantis Investors).

We can’t tell you when the recession will reach the halfway point, if it hasn’t already, but the best way to capture it is to remain invested. As a reminder, we made two fixed income investment changes to shorten duration and have avoided bond losses from rising interest rates (see below for more details). We remain cautiously optimistic on the strength of the American consumer to make it through this period of higher inflation and believe better returns are in the future for globally diversified portfolios with a value and size bias. We also know we’re in a period of high volatility that will likely be with us for the foreseeable future. Research suggests, the best way to take advantage of high volatility is to monitor portfolios more often to take advantage of rebalancing opportunities and continue to make retirement plan contributions. We are currently monitoring portfolios weekly for 20% asset drift from target.

We would like to remind everyone that you don’t own the highs and you don’t own the lows, you own the long-term performance of your portfolio. The best course of action is to focus on the decisions you can control to achieve the success of your financial plan. We are here to support your continued success and would be happy to answer any questions or concerns.

For those who would like a deeper dive into the details, please continue reading…

World Asset Class 3rd Quarter 2022 Index Returns

U.S., International Developed, Emerging Market and Global Real Estate stocks were all down in the third quarter, following the negative short-term momentum from the first and second quarters. U.S. and Global Bonds were also down as the level of interest rates increased on short and longer maturities. For the broad U.S. Stock Market, the third quarter return of -4.46% was well below the average of 2.1% since January 2001. International Developed Stocks returned -9.2%, which was below the long-term average quarterly return of 1.3%. Global Real Estate Stocks returned -11.12%, well below the asset class’s average quarterly return of 2.2%.  Emerging Market Stocks returned -11.57%, below the average quarterly return of 2.4%. The global supply chains are still experiencing production issues, and higher inflation persists in many categories. The Federal Reserve hiked rates 75 bps at the last two meetings and continues to signal rate increases of 50 to 75 basis points for the next two meetings of the year. However, the increased interest rate environment is only having an impact on slowing demand, not increasing supply to reduce inflation. The entrenched inflation outlook and higher probability of a hard landing sent stocks down for the quarter. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

As September 30th, 2022, US stocks (as defined by the Russell 3000 Index) led all categories by declining the least, down -17.63% in the last year (as you will see below, US Large Cap Value stocks were only down -11.36% in the last year, over 6% better). Global Real Estate stocks lost -20.49%, while International Developed stocks lost -23.91% during the past year. Emerging Market stocks lagged with a one-year return of -28.11%. Over the past five years, U.S. stocks were up 8.62% annually, while International Developed stocks were down -0.39% annually, Emerging Market stocks were down -1.81% annually, and Global Real Estate stocks were up 0.17% annually. Over the past 10 years, the U.S. stock market (up 11.39% annually) is well ahead of International Developed (up 3.62% annually) and Emerging Market (EM) stocks, which are up 1.05% annually over the past 10 years. We continue to believe EM might be the place to be for the next 10 years, but so far, the asset class continues to underperform. During the third quarter, the dollar continued strengthening, which hurts international returns.

Taking a closer look within U.S. stocks during the third quarter, we can see that market wide results were down -4.46%. Small Growth stocks finished the quarter slightly positive, beating Small Values stocks, which were down -4.61%. Large Growth stocks were ahead of Large Value stocks by a bit more than 2%. Small cap stocks were ahead of large cap stocks, while growth was ahead of value:

If we extend our analysis of U.S. stock over longer time periods, large growth is no longer the leading asset class over the past 1 year, but still leads over 3, 5 and 10 years. Large Value stocks are now in the lead for the past year. The lofty valuations of growth stocks are coming back to earth. It is worth noting that Market wide results for the past 10 years are still strong, up 11.39% annually.

The U.S. business cycle looks to be in the late stages of recovery from the global pandemic, and GDP growth was negative for the past two quarters, which is the basic definition of a recession. However, the GDP calculation has a heavy influence from inventories and net purchases of imports, which could be viewed as positive consumption. It is difficult to see a heavy recession with the job market still so strong. All eyes are on the Fed pivot, which means a change in stance from restrictive monetary policy back to accommodative. The timing of the pivot is unknown; and Powell has recently stated the timing of hikes is indefinite until progress is made on inflation. We have a Fed that has promised to prioritize price control over maximum employment. It is a difficult but necessary task since inflation is an extra burden on all households and hurts those living paycheck to paycheck the most. It may feel like a recession has already started for lower income households and small business owners. However, in the aggregate, the average wage earner is doing well; and jobs are still plentiful. The U.S. job market remains very tight; and until it breaks down, we are not likely to experience a hard landing from the Fed.

International Developed Stocks were negative in local currency, and more negative in US dollars, since the dollar appreciated against most foreign currencies. The Euro is now below parity with the U.S. dollar, $0.98, down from $1.18 just over one year ago. The value premium (value-growth) and the size premium were negative (small cap stocks underperformed large cap stocks) for the third quarter. The currency effect served as a headwind to international stock returns during the quarter, as US currency returns were lower than local currency returns. Our investment funds are priced in U.S. dollars and the dollar’s strength from the start of this year continues through the third quarter.

Over longer time periods, the value premium (value-growth) is positive over the past 1 year, but negative for the past 3, 5 and 10 years. The size factor premium (small cap-large cap) is now negative in the past quarter and year, but it is positive over the past 3 and 10 years. There is still plenty of room for value to catch growth over longer time periods in the future.

Shifting the commentary to fixed income, bond market returns around the world were negative during the third quarter, due to a sizeable increase at the short end of the curve, as the Fed lifts the overnight lending rate, and an increase at the long end of the curve with the Fed bond selling program (quantitative tightening or QT). More rate increases are expected in the final quarter of this year and the QT program is expected to continue for many years. The yield on the 5-year Treasury note increased by 105 basis points, ending the quarter at a yield of 4.06%. The yield on the 10-year Treasury note increased by 85 basis points, ending the quarter at a yield of 3.83%. And the 30-year Treasury bond yield increased by 65 bps to 3.79%. Here is the U.S. yield curve, and you can see how yields jumped at the short end to invert the curve from 2 to 10 years and make the curve flat from 10 years out to 30 years (current yield curve in grey, one quarter ago in blue, and one year ago in green):

As a reminder, LTWM acted in response to the expected increase in rates. We made the decision on April 22nd to sell and limit the losses in our most conservative fixed income asset class and replace it with the money market, since rising short term rates improves the yield on the money market and its par value of $1 does not lose money when short-term rates increase. Then on May 5th, we sold our highest duration fixed income holding, which had a duration of 6 and replaced it with zero duration USFR, an ETF that invests in floating rate U.S. Treasury Bills, which increase in value with higher interest rates. Both decisions were made to ensure we are following the philosophy of a stable reserve for fixed income. The stable reserve is used to rebalance out of when stocks decline. We have not yet reached a rebalance point where we would sell bonds and buy stocks, but some asset classes are close. The two steps were meant to protect portfolios from the large losses of longer maturity bonds.

Notice below, the highest third quarter, YTD, 1 Year and only positive bond return is for the US 3-Month Treasury Bill Index, while the US Government Bond Index Long was down 9.6% for the quarter and a whopping -28.88 year to date (YTD). It is easy to lose lots of money with long term bonds in a rising rate environment and we have protected client portfolios from large bond losses. Over longer periods, the best returns are still with High Yield Corporate Bonds, due to the strong performing U.S. economy in the past decade, but the TIPS index is now the leader for the past 5 years. Here are the period returns:

On June 15th, the Fed raised its benchmark lending rate by 75 basis points to 1.75%, another 75 bps at its meeting on July 27th and 75 basis point at its September meeting to 3.25%. The Fed is also executing quantitative tightening (selling bonds) at a rate of $95 billion a month, which is designed to raise interest rates at the long end. Currently the Fed balance sheet is at $8.9 trillion, so it will take years to normalize its portfolio of bonds. The Fed is a major seller in the Treasury bond market and has reduced the liquidity of the market as many participants have paused purchases. So far, there hasn’t been any issues for Treasuries, but the in the UK, the Bank of England had to step in to save several Pension Funds from collapse. The emergency measures included a two-week program of purchasing long-term bonds, known as Gilts. After the intervention, the 30-year gilt fell by more than 100 basis points and the 10-year Treasury dropped from 4.06% down to 3.7% on Wednesday, September 28th. The 10-year Treasury yield has crept back up to 3.9% at the time of this writing. The Fed has many tools to combat any dislocations or heavy volatility in the bond market. For the time being, the stock market remains highly correlated with the bond market, and both are going down together. Any Fed pause on rate hikes or bond selling, could send stocks up considerably. For now, the Fed is careful to communicate its dedication to fighting inflation with continued rate hikes.

One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.

CONCLUSION

The entrenched inflation outlook and higher probability of a hard landing sent stocks down to new lows at the end of the third quarter. However, the labor market remains strong; and companies are not responding to the slowdown by letting go of workers. The 3rd quarter earnings season, which is just getting underway, will be closely monitored for clues on the health of the global economy. The financial news will be filled with forecasts and the news will likely get out of control with sensational stories leading up to the mid-term elections next month. If you would like to review the research that proves the political party in power has little effect on the direction of stocks, you can view our website blog here.

Our recommendation, as always, is to tune out the news and focus on what you can control with your financial well-being. Please contact us with any questions or concerns. We are here as your financial steward. We will also be hosting in person client events on the East and West coast during November and hope to see you in person.

Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2020, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2020, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2020 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2020 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.  Diversification does not guarantee investment returns and does not eliminate the risk of loss.  

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Principal Risks:

The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.

Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.

The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.

Fixed Income Portfolios:

The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.

Risk of Banking Concentration:

Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.

The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities.  The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such.  The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information. 

Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements.  Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time.  Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.

Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.