The hope of a Fed pivot, which drove markets higher in July, faded in the latter half of Q3 as the Fed made it clear that they would continue with their aggressive rate hiking campaign until inflation is brought down to a reasonable level. During the quarter, investors saw the Fed hike rates 150 bps, in addition to increasing their interest rate expectations for 2023 by nearly 100 bps (3.75% as of June vs. 4.625% as of September). The result was a rise of 132 bps in the yield of the 2-year treasury, while the yield on the 10-year soared by 81 bps. This weighed heavily on equity markets across the globe, with the S&P 500 declining by -4.88% on the quarter, while non-U.S. developed stocks experienced losses of more than -9%. Investment grade bonds fell generally in-line with equities (-4.75%), as sharply higher interest rates pressured bond prices lower.
The S&P 500 ended the month firmly in bear market territory, with YTD losses totaling -23.87%. The rally that started Q3 changed course dramatically in August and September, as continued interest rate hikes and hawkish language from the Fed dashed investor hopes for a near-term pivot. Large growth stocks offered a slight performance advantage over their value counterparts during the quarter but continue to trail by a wide margin for the year (-30.66% vs. -17.75%). These outsized losses for the Russell 1000 Growth index have largely been driven by several of the FAANG+M stocks, which account for a disproportionate share of the index. For instance, on the year, Microsoft, Amazon, and Alphabet have all fallen by more than -30%, while Meta Platforms has declined by nearly -60% YTD.
The storyline dominating non-U.S. markets has been the dollar, which has risen by an astounding 17%+ YTD (as measured by the DXY index) on the back of aggressive interest rate policy within the U.S. and a general flight to safety. This has put extreme pressure on returns for U.S.-based investors in nondollar assets, detracting more than 1200 bps from MSCI EAFE returns and over 600 bps from returns for the MSCI EM index. Despite this massive headwind, developed and emerging markets stocks are trailing the S&P 500 by just 322 bps and 329 bps on a YTD basis, both declining by approximately 27%. We can attribute this is to their natural underweight to high valuation technology and communication services stocks, which have suffered significant losses during 2022’s selloff.
Investment grade bonds continued to struggle in September, declining -4.32%, the steepest monthly loss for the Bloomberg Aggregate Bond index in more than 40 years. Losses were largely driven by a combination of sharply higher interest rates, with the 10-year treasury briefly exceeding 4% (intraday), and widening credit spreads, which moved out as recession fears intensified and equites sold off. This leaves the index lower by -14.61% on a YTD basis, its worst 9 month stretch of performance on record. From a statistical standpoint, such losses equate to a 3.5 standard deviation event, which has just a 1 in 5,000 rate of occurrence. That said, investors can take some solace in the 4.75% yield on the Bloomberg Aggregate index. Not only is this much more attractive than the index’s sub-2% yield on January 1st, but the starting yield of the index tends to be highly predictive of future fixed income returns.
Broad-basket commodities retreated in September, falling -8.1%, as investors priced in the higher likelihood of an economic hard landing orchestrated by the Fed. Lower demand from China also contributed to the negative return, as the government continues to implement restrictive “Zero-COVID” policies. As the largest component of the Bloomberg Commodity TR Index, Crude Oil had an outsized impact on performance, falling -9% in September. The only positive returns of note were seen in wheat and silver prices, which rose 10.5% and 6.7%, respectively. Despite giving back some of their YTD gains, commodities remain higher by 13.6% on the year, outperforming the S&P 500 by more than 37% thus far in 2022.
Closed End Funds
Closed end funds had a difficult September, as industry-wide discounts gapped out to levels not seen since 2020. During the month, CEFs were hit with a proverbial perfect storm of headwinds, as all their primary betas worked against them; interest rates rose substantially, credit spreads widened, and equity market volatility increased. However, from a tactical investment standpoint, such a move greatly improves the overall attractiveness of CEFs, which for much of the year had been trading within their long-term historical average discount. We now have the average fund trading at a discount in excess of -6.5% vs. an average of -4.5%, while offering a yield of 8.7%.
iCM Tactical Strategies
iCM’s tactical strategies, which utilize ETFs and/or mutual funds, gave back some ground to their blended benchmarks on the month, as U.S. dollar strength weighed on the returns of non-U.S. assets. However, on the year, relative performance continues to be strong. Our overall fixed income strategy has benefitted from a slight underweight to duration, as rates have increased meaningfully from the start of the year, while performance for our general equity strategy has been supported by an out-of-benchmark position in commodities and a sizable overweight to value within our U.S. equity allocation.
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