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Investors should lean on quality assets and diversification to weather choppy fourth quarter markets



Last week, the S&P 500® Index dropped 2.9%, as the major U.S. stock barometer is now down in six of the last seven weeks. The Index posted a fresh year-to-date intraday and closing low on Friday, falling below 3,600 and touching its lowest levels since November 2020. The NASDAQ Composite fell 2.7% on the week, while the Dow Jones Industrials Average finished lower by 2.9%. The 30-stock index is down more than 22% from its early January high and just last week joined the S&P 500 and NASDAQ in their bear market misery.

The path of least resistance for asset prices in September and during the third quarter remained firmly entrenched to the downside. On Thursday, we believe Cleveland Federal Reserve President Loretta Mester encapsulated the tone of the month and quarter best when she said in a speech, "a recession won't stop the Fed from raising rates." Notably, stocks and bonds took another leg lower in late September after the median fed funds target rate projection increased for 2022 and 2023. During the month, Fed Chair Jerome Powell and company aggressively pushed back on any narrative that suggested slight declines in inflation would lead the central bank to ease monetary conditions next year. Instead, Federal Reserve officials reinforced their hawkish stance, expressed an unwavering commitment to bringing down inflation, and warned that history strongly cautions against prematurely easing policy in the face of such intense price pressures. Bottom line: The Fed Put is dead for now (i.e., the Fed changes course and eases policy because of building economic pressures).

In September, the S&P 500 and NASDAQ fell for the second straight month, falling 9.3% and 10.5%, respectively. The S&P 500 posted its worst September in twenty years and its worst month of performance since March 2020. The NASDAQ saw its worst month since April and its second worst month since 2008. Growth (down 10.2%) underperformed Value (down 9.1%), as all S&P 500 sectors were lower on the month. Treasury prices continued to decline, with the Bloomberg U.S. Government Bond Index down 3.4% in September. The 2-year U.S. Treasury yield jumped 80 basis points in the month, while the 10-year U.S. Treasury yield rose 68 basis points. The relentless onslaught of higher yields, tightening financial conditions, growing concerns over a global economic hard landing, elevated geopolitical risks, and a weakening earnings outlook undermined investor sentiment and pushed asset prices lower last month.

In Q3, U.S. equities declined for a third straight quarter; yield curve hit its most inverted level this century

Unfortunately, the story wasn't much different when looking at the third quarter as a whole. U.S. equities were again lower for a third straight quarter, with the S&P 500 finishing Q3 down 5.3%, the NASDAQ off 4.1%, and the Dow in the red by 6.7%. Moreover, a summer rally that saw the S&P 500 win back half its year-to-date losses faded by mid-August, turning into new lows for the major stock averages by the end of Q3. This was undoubtedly a disheartening development for investors hoping markets had sailed through the worst of the storms. With the S&P 500 off nearly 25% through the first nine months of the year, the U.S. stock benchmark has now suffered its third-worst performance at this point in the year since 1931, according to Bloomberg. And while bonds have helped mitigate declines versus an all-stock portfolio this year, the Bloomberg Universal Bond Index is down 14.9% year-to-date through September, one of its worst years in decades.

During the third quarter, the yield curve hit its most inverted level this century. The 2-year U.S. Treasury yield shot up nearly 130 basis points in Q3 to over 4.20%, while the 10-year Treasury yield increased by 85 basis points to just over 3.80%. The Bloomberg U.S. Government Bond Index fell 4.3% in Q3. Further, most major U.S. bond averages also finished lower during the previous quarter.

On the currency front, the U.S. Dollar Index rose over +7.0%, its fifth straight quarter of gains and its largest move since Q1'15. West Texas Intermediate (WTI) crude dropped nearly 25% in Q3 on weaker global growth and heightened recession fears, while Gold ended down 7.5%.

Volatility expected until market has clarity on inflation pressures; third quarter earnings expected to decline

So what now? In our view, stocks and bonds may continue to see further volatility in the fourth quarter until there is more clarity that inflation pressures are moderating consistently on a month-over-month basis. We also believe interest rates must find an equilibrium level before stock and bond prices can settle into a more stable trading pattern. Currently, disruptions in the currency markets are causing new ripple effects, adding another dimension of uncertainty to the macroeconomic environment. Recent efforts to step in and support their currencies against a surging dollar by Japan's Finance Ministry and People's Bank of China or actions by the Bank of England to help mitigate the added inflation pressures of specific fiscal proposals are creating new headaches for traders.

Importantly, we believe earnings estimates for next year are too high. Lower stock valuations could begin to reflect a more significant chance of a recession next year, resulting in lower-than-expected earnings growth and profit margins. We expect the upcoming third quarter earnings season later this month to be a critical gauge in shaping how analysts adjust their profit forecasts for the next few quarters. Bottom line: We believe profit forecasts are headed lower based on the current economic environment, which could challenge stock prices in the fourth quarter. Notably, Q3'22 S&P 500 earnings per share (EPS) is expected to grow by just +3.2% year-over-year and forecast to be negative when Energy is excluded. Per FactSet, Q3 S&P 500 EPS estimates dropped 9.8% over the third quarter, yet estimates for 2023 barely budged. Elevated inflation, high input costs, still disrupted supply chains, and potentially lower demand is not an environment that would lead us to believe there is a high likelihood that corporate profit growth can come out of this downturn unscathed.

Investors should think long term and prepare to weather more volatility heading into the fourth quarter

In our view, investors should take a slightly more defensive position at the start of the fourth quarter. This includes tactically underweighting international stocks, increasing allocations to Alternative Investment Strategies, continuing to favor Value over Growth, and shifting toward a defensive versus cyclical bias across sectors. In addition, investors should continue to lean on diversification, select quality assets in the U.S., and recognize that security selection could play a more prominent role in generating returns.

With that said, near-term conditions in the market have become very oversold after September's selloff. We expect selling pressure to subside at some point, with technical factors potentially holding more sway over the very short term. In addition, more favorable seasonality factors later this year could also help stock prices stabilize at levels higher than where they closed the third quarter. Longer-term, stock weakness should be viewed as an opportunity to acquire quality assets at reduced prices. In our view, valuation is one of the most predictive factors in guiding future stock gains over the long term. Based on history, buying quality assets at reduced prices tends to reward investors over time. Eventually, this bear market will trough and present solid entry points for sidelined cash and begin a new recovery phase for existing assets. Our advice: plan to weather more storms during the quarter, avoid timing mistakes and focus on what you can control. This bear market, too, shall pass. Think longer-term when others are laser-focused on the here and now.

Jobs report headlines this week; Verisk estimates Hurricane Ian caused over $100 billion in total economic damage

Finally, Friday's September nonfarm payrolls report will help shed further light on labor market conditions in the U.S. and as growth trends slow. FactSet estimates call for September payrolls to increase by +250K, which would be a step lower from the +315K pace seen in August and the +526K jobs created in July. In addition, the unemployment rate is expected to hold steady at 3.7%. During the week, September Institute for Supply Management (ISM) manufacturing and nonmanufacturing updates should show further declines in economic activity.

And after the deadliest storm to hit Florida in over 60 years, with Verisk estimating roughly $40 billion to $60 billion in insured losses for Florida and South Carolina and well over $100 billion in total economic damage, the two states will begin their long journey to recovery after Hurricane Ian. Most believe it will take years for the affected areas to fully recover.

Sources: FactSet and Bloomberg. FactSet and Bloomberg are independent investment research companies that compile and provide financial data and analytics to firms and investment professionals such as Ameriprise Financial and its analysts. They are not affiliated with Ameriprise Financial, Inc.

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