The third quarter of this year started out so promising. After the worst first half since 1970, the S&P 500 rallied 17.4% from its June 16 low to its August 16 high. But stronger-than-expected inflation reports, and a hawkish Fed proved to be too much for the market, and the S&P 500 gave back all its gains and then some, ending Q3 at new lows for the year. The S&P 500 is down 24.8% year-to-date through the third quarter, its worst first nine months since 2002 and fourth worst since 1926. Other risk-on indices like the Russell 2000 (-25.9%), MSCI Emerging Markets (-28.9% in U.S. dollars), Nasdaq (-32.4%), and Bitcoin (-58.1%) are all down even more.

Normally, when equity markets suffer an extended decline, risk-off assets like Treasury bonds usually offer a place to hide… but not this year. The Bloomberg Barclays Long-Term U.S. Treasury Index tumbled 9.6% in Q3, bringing 2022 losses to 28.8%. The U.S. Aggregate Bond Index (AGG) is down 14.6% YTD. A 60/40 portfolio of the S&P 500 and the U.S. Agg is down 20.2% through September, its worst first nine months since 1974 and third worst since 1926.

The reason for all the capital market carnage is that the global economy is currently in a sustained slowdown due to waning monetary and fiscal support, stubbornly high inflation, and rising geopolitical risk. While the slowdown remains moderate so far, the risk of severe recession increases as we enter 2023. With global inflation at multi-decade highs, most of the world’s central banks have made it clear that fighting inflation is their primary goal. For many, it’s their single mandate. To them, the cost of sustained higher inflation, which impacts the poor and retirees and increases uncertainty among businesses, outweighs the cost of a cyclical economic slowdown. As a result, we are currently seeing some of the broadest and fastest global central bank tightening in history and increasingly restrictive policy is expected. The latest Economic Projections released by the Federal Reserve Board show the median expectation for 2023 is a Federal Funds Rate of 4.6%, up from the current 3.25% as elevated inflation rates persist. We expect inflation to come down eventually, but not until after growth slows and labor markets weaken. Higher rates amid tighter financial conditions mean the outlook is increasingly gloomy, with recessions a very real possibility in most major economies.

The main warning comes from the inverted yield curve, where the spread between the yields on the 10-year and 2-year Treasury bonds is the most negative in 40 years. Some of the leading indicators for the U.S. economy, such as the Institute for Supply Management’s index for new orders, have also softened. The indicators that the Fed focuses on, such as payrolls and wages, remain overheated. These labor-market trends tend to lag the broader economy. This creates the risk that the Fed will continue to tighten even as the economy weakens. It also means Fed Chair Jerome Powell is unlikely to navigate a pivot to a less hawkish stance before early 2023.

The “good news” is the S&P 500 is already down close to 25%, close to the average decline of 29.7% in the 30 bear markets that have occurred since 1929, according to Ned Davis Research. However, the firm notes that bear markets that coincide with recessions typically decline close to 35% on average and last for 15.3 months. That would put the S&P 500 at approximately 3,100 by April 2023 if the statistics hold and we have a recession-led bear market. At Gainplan, we continue to remain defensive with an underweighting to equities and will monitor the progress of this bear market and make changes accordingly.

*All data sourced from Ned Davis Research, Inc. as of 10/10/2022