Financial Market Review: Third quarter 2022

Global equities (-4.7%) fell in the third quarter, ending the period with a 21.4% loss year to date. Risk-off sentiment was driven by high inflation, rising interest rates, geopolitical turmoil, and growing signs of a global economic slowdown. The US Federal Reserve (Fed) hiked its target interest rate by 150 basis points (bps) over the quarter in an effort to rein in decades-high inflation. Fed officials stated that the central bank would continue raising interest rates until it was confident that inflation was under control, acknowledging the unfavorable impacts the policy will have on consumers and businesses. Eurozone inflation increased 10% year over year in September on the back of soaring energy prices. European energy ministers responded to the continent’s energy crisis with a €140 billion plan to aid consumers and businesses, including revenue caps and clawbacks on energy profits. European gas prices continued to skyrocket as a result of the war in Ukraine; tensions with Russia were further exacerbated by damage to the Nord Stream pipeline, which NATO attributed to an act of sabotage. The European Central Bank (ECB) ended its negative interest-rate policy, raising rates by 125 bps over the quarter. In sharp contrast, the Bank of Japan (BOJ) maintained its highly accommodative yield-curve control policy, leading to further declines in the yen and prompting the BOJ to intervene to support the currency for the first time in 24 years. The People’s Bank of China (PBOC) cut interest rates in an attempt to revive the country’s sputtering economy. China’s strict COVID containment policies and property market disarray weakened consumer, producer, and investment activity. 

Global fixed income sectors declined sharply during the third quarter. Concerns about persistent inflation and ongoing global monetary policy tightening contributed to escalating volatility, leading to official interventions in the UK and Japan. Excess returns over duration-equivalent government bonds varied across sectors, driven by elevated global recession risks and disruptions to Europe’s energy supply. The US dollar strengthened versus most currencies. 

Commodities (-10.3%) declined, as only one of the four sectors generated positive returns. The shift to tighter monetary policy spurred speculation of a sharp slowdown in global growth, hurting demand for commodities, which were also hit by a surging dollar.

Equities

US
US equities (-4.9%) fell for the third consecutive quarter, ending September with a 23.9% loss year to date. Risk sentiment deteriorated on fears that aggressive interest-rate hikes and tighter financial conditions would constrict economic growth and drive the US to recession. Stocks suffered steep losses in September after a larger-than-expected rise in core consumer prices showed that inflation continued to mount across broad areas of the economy. Fed Chair Jerome Powell acknowledged that while there is considerable uncertainty about the trajectory of inflation and a greater possibility of recession, the central bank is committed to raising interest rates and keeping them elevated for longer until there is clear evidence that price pressures are abating. As expected, the Fed raised interest rates by 75 bps in September — the third straight increase of this magnitude. However, markets were surprised by the bank’s more hawkish policy forecast that signaled rates would continue to rise rapidly to a higher level than previously anticipated. Median projections from Fed officials revealed that rates would increase to 4.4% by the end of 2022 before peaking at 4.6% in 2023, above the market’s expectations and significantly higher than the bank’s previous forecast. Economic headwinds weakened the outlook for third-quarter earnings, as analysts’ bottom-up earnings-per-share estimate for companies in the S&P 500 Index decreased by 6.6% during the quarter. President Joe Biden signed into law legislation to lower prescription drug prices, boost renewable energy, and impose new taxes on corporations, enhancing Democrats’ prospects of maintaining control of Congress after midterm elections in November. 

Economic data released during the quarter signaled that the US economy slowed but remained resilient despite tighter financial conditions, persistent inflation, and greater economic uncertainty. A strong labor market boosted consumer spending and inflation, strengthening the Fed’s resolve to aggressively raise interest rates. Despite an uncertain economic outlook, surprisingly robust nonfarm payroll growth signaled that tighter monetary policy did not significantly curtail labor demand. A steady flow of new workers raised the participation rate to 62.4% in August — the highest since March 2020 — helping to ease labor cost pressures and lifting the unemployment rate to a six-month high of 3.7%. Falling gas prices and a favorable labor market spurred gains in retail sales and consumer spending in August, although stubbornly high inflation, slowing wage growth, and dwindling savings pose headwinds to the demand for goods and services. The Conference Board’s Consumer Confidence Index improved significantly during the quarter amid improving views of current conditions and more optimism about future expectations. Waning demand and soaring mortgage rates fueled a broad deterioration in the housing market. The manufacturing sector expanded at a slower pace during the quarter amid weaking demand, while the services sector ended firmly in expansionary territory in August as employment improved, supply price pressures eased, and measures of business activity and new orders rose to their highest levels in 2022. Small-business sentiment advanced during the quarter as companies were less pessimistic about business conditions and the inflation outlook. 

Within the S&P 500 Index (-4.9%), nine of the 11 sectors posted negative results for the quarter. Communication services (-12.7%) was the worst-performing sector, driven by weakness in diversified telecommunication services (-25.1%), media (-23.1%), and interactive media & services (-12.7%). Real estate (-11.0%) fell as REITs were weighed down by housing market pressures. Materials (-7.1%) was another notable underperformer, driven by containers & packaging (-18.6%) and chemicals (-5.0%). Consumer discretionary (+4.4%) contributed positively, buoyed by automobiles (+16.0%) and internet & direct marketing retail (+6.3%).

Europe
European equities (-4.1%) were dragged lower by deteriorating market sentiment and significant macroeconomic headwinds, including tightening financial conditions, soaring energy prices, and increasingly hawkish central bank policies. Europe tipped closer to recession following a series of downbeat economic releases that showed a deepening cost-of-living crisis and weakening activity across the manufacturing and services sectors. The region’s energy woes intensified after natural gas costs soared to record highs and electricity production was curtailed by abnormally hot temperatures and drought. The unrelenting surge in energy prices upended the economy and threatened to fracture European unity, spurring policymakers to implement new measures to alleviate the financial impact on consumers and businesses. European Union (EU) energy ministers also agreed on a proposal to reduce electricity demand and to redistribute the energy industry’s surplus profits to households. Annual headline eurozone inflation surged to a record high of 10.0% in September, up from 9.1% in August, as price increases broadened beyond food and energy to nearly all segments of the economy. European central banks implemented outsized interest-rate hikes in September, while the ECB intensified its efforts to curb the relentless rise in inflation, hiking rates by 50 bps in July and 75 bps in September. The bank also introduced a new bond-buying program to prevent escalating borrowing costs from precipitating a debt crisis. 

Europe’s manufacturing downturn accelerated during the quarter as the Eurozone Purchasing Managers’ Index (PMI) dipped to a 27-month low of 48.4 in September. Firms’ expectations for next year fell sharply amid weakening demand and higher input and output prices, which reaccelerated due to higher energy costs. Preliminary composite PMI data for September showed that services sector output dropped markedly, particularly in Germany, which experienced the largest decline since June 2009. Economic sentiment fell during the quarter, dropping sharply and by more than expected in September; industry confidence fell for the seventh straight month, while consumer confidence plummeted to a record low as economic uncertainty abounded. Eurozone unemployment held at an all-time low of 6.6% in August, as the labor market remained resilient despite strong macroeconomic headwinds. 

In Italy (-2.2%), a right-wing coalition led by Giorgia Meloni won a decisive victory in the country’s snap election. Meloni pledged to maintain continuity with former Prime Minister Mario Draghi’s key policies, but markets were anxious about the new government’s ability to address the mounting pressures on Italy’s economy and the greater likelihood of frictions with the EU. In the UK (-2.9%), stocks plunged, and the British pound tumbled to a multi-decade low after Chancellor Kwasi Kwarteng’s unorthodox debt-financed plan of tax cuts sparked a historic increase in borrowing costs and forced the Bank of England (BOE) to temporarily purchase long-term gilts to calm financial markets. New Prime Minister Liz Truss’s government hoped that radical tax cuts and deregulation would raise the country’s sluggish growth rate, but the widespread criticism of this approach, the lack of fiscal clarity, and severe financial turmoil significantly dented confidence in the government and fueled concerns about the sustainability of government debt at a time of skyrocketing inflation and interest rates. In Germany (-6.7%), economists slashed forecasts for economic growth as the country faced a plethora of shocks. The government announced a sizable €200 billion plan to push electricity and gas prices down for businesses and consumers.

Emerging markets
Emerging markets (EM) equities (-8.0%) slid lower in the third quarter. Within EM, Latin America moved higher, while Europe, the Middle East, and Africa (EMEA) and Asia ended down.

Latin American equities (+6.2%) were bolstered by Brazil (+12.4%), whose central bank hiked interest rates by 50 bps, to 13.75%, up sharply from a low of 2.0% in 2020. However, the bank’s future guidance was more dovish than expected, signaling that its aggressive policy-tightening cycle may be nearing a peak. President Jair Bolsonaro introduced election-friendly policies aimed at subsidizing low-income households and supported legislation to cap state-level taxes on essential services. At the end of the quarter, Brazilians readied for the first round of the most polarized presidential election in decades, with polls indicating a tighter race between President Bolsonaro and former two-term leftist President Luiz Inácio Lula da Silva. In Mexico (-5.7%), consumer prices rose at a faster-than-expected pace, prompting the central bank to unleash 75 bps rate hikes in August and September as it fought to curb the highest inflation since the turn of the century and to stem a decline in the peso. Chile (+5.6%) benefited from soaring prices on lithium exports, while Chilean voters rejected a proposed left-leaning constitution, dealing a heavy blow to President Gabriel Boric. 

EMEA equities (-1.7%) slipped, with Eastern European countries continuing to feel the spillover effects of Russia’s escalating war with Ukraine. Many traditional supply routes for food and energy have been cut off or remapped, exacerbating inflation in countries such as Poland (-17.2%) and the Czech Republic (-18.2%). South Africa’s (-3.4%) energy crisis pressured the rand, strained households, and threatened the country’s industrial sector. Operational and structural problems at state-owned utility Eskom have led to rolling blackouts that are costing the country an estimated US$40 million a day. With no long-term solutions in sight, investor confidence was rattled as the prospect of power rationing and lower production loomed. Countries in the Persian Gulf have benefited from exports of gas and oil at a time of strained energy supplies and high demand. However, a strengthening US dollar and slowing global economic growth weighed on markets in the region. 

Asian equities (-10.4%) were dragged down by China (-21.6%), where a steep drop in stocks reflected anxiety about the health of the economy, strains from the zero-COVID approach and slowing global demand, and a worsening property market crisis. The number of home buyers refusing to pay mortgages for unfinished housing projects rose rapidly, increasing the risks of contagion to other parts of the financial system and prompting the State Council to mobilize up to US$148 billion of loans to help developers complete unfinished projects. The manufacturing sector contracted in August, and several other key activity measures indicated slower economic growth, spurring more downgrades to GDP forecasts. Rapidly rising interest rates in the US have accelerated capital outflows from China and made it difficult for the PBOC to provide more stimulus for the economy without further pressuring the renminbi, which continued to fall precipitously against the US dollar. Government authorities increased policy support, although there were doubts whether these measures would revive the ailing economy. The trade-dependent economies of Taiwan (-8.2%) and South Korea (-7.8%) were hampered by slowing global growth, which threatened to curb the demand for semiconductors and electronic equipment — two key exports. India (+10.0%) realized good gains as favorable economic data early in the quarter pointed to a strong recovery. However, an expanding trade deficit driven by high commodity prices and a weakening rupee drove inflation higher, hurting local businesses and consumers and increasing pressure on the central bank to lift interest rates.

Fixed Income

Global economic growth indicators displayed some resilience during the third quarter, even as recession risks mounted. US GDP contracted for the second consecutive quarter, although officials stopped short of declaring a recession given the strength of the labor market and industrial production. Inflation data offered scant evidence of easing price pressures, with particularly high inflation readings across the UK, eurozone, and US. A notable exception was China, where moderate inflation enabled the central bank to pursue much easier policy than other global central banks. While US labor market strength persisted, the housing sector was markedly weak following a sharp increase in mortgage rates and slowing home-price appreciation. The eurozone manufacturing and services PMIs contracted, dragged lower by higher costs, weaker demand, and increasing economic uncertainty. Japanese retail sales and household spending exceeded estimates despite a resurgence in COVID cases. China’s economy faltered amid strains from the country’s zero-COVID policy, slowing global demand, and the ongoing property market slump, although the official PMIs ended the quarter slightly inside expansionary territory as supply-chain bottlenecks eased. UK consumer confidence plunged to a record low amid the country’s historic cost-of-living squeeze. 

Persistent inflation and tighter monetary policy resulted in negative returns across most global sovereign markets. Central banks in most developed markets reinforced their hawkish intentions and expressed a willingness to keep policy restrictive despite slower economic growth and weaker labor markets. At the Jackson Hole economic symposium in August, Fed Chair Powell indicated that the Fed is resolutely focused on fighting inflation. The Fed delivered its third consecutive 75 bps rate hike in September and most other central banks followed suit, with many European and select Asian countries seeing outsized rate increases. US real yields rose to their highest levels since 2010 while breakeven inflation rates declined. UK gilt yields surged after the new chancellor unveiled a tax-cutting mini budget. The BOE subsequently delayed quantitative tightening until the end of October and carried out emergency operations to stabilize gilt yields after volatility spiked following the expansionary fiscal policy announcement. Canadian 10-year yields declined amid falling crude oil prices and a below-consensus inflation print. In sharp contrast to other central banks, the BOJ retained its accommodative policy stance, while Japan’s Ministry of Finance intervened in the currency market for the first time since 1998 to support the yen.

Currencies

The US dollar rallied to its highest level in two decades as it became increasingly clear that the Fed would tighten policy more aggressively to counter persistently high inflation. UK fiscal concerns sparked market turmoil and risk aversion late in the quarter, driving the US dollar higher. The euro dropped below parity with the dollar for the first time in almost two decades as hawkish US policy and intensifying recession risks in Europe battered the euro. The Japanese yen sank to a multi-decade low due to a widening interest-rate differential between the US and Japan. Currency intervention by Japan’s Ministry of Finance temporarily reduced volatility but was unable to stem the currency’s decline. The British pound fell to an all-time low against the US dollar in September after the new British government’s fiscal policy announcement raised concerns about the UK’s fiscal sustainability. The currencies of countries with current account deficits were pressured, particularly the New Zealand dollar. The Norwegian krone fell in line with oil prices, even as the Norges Bank signaled a more gradual approach to policy tightening and lowered its terminal-rate projections. Many EM currencies experienced high single-digit declines versus the US dollar. Slowing export growth in China pushed the Chinese yuan below the key level of 7 versus the dollar. The PBOC attempted to reduce pressure on the yuan by increasing the risk reserve requirement on forward foreign exchange sales to 20%, increasing the cost of short yuan positions. The Indian rupee dipped to an all-time low.