Dear friends,
The 3rd quarter saw the US markets continue to be dogged by persistently high inflation with levels not seen since the early 1980’s. The underlying cause is partly lingering supply chain issues with a large contribution (over 60%) coming from energy and auto-related costs. Some of the supply chain issues (which began cropping up post-Covid lock downs) are now related to the on-going war in Ukraine. Dovish market observers and economists have vocally opposed the Fed’s aggressive interest rate policy response, claiming (not without merit) that the inflation figures are being driven by exceptional factors. Thus far, these arguments have not swayed the majority of voting members among the Fed board and 2022 has seen rates rise at a much steeper pace than the Fed themselves had projected just last year. The Fed has indicated a commitment to raising rates until they see inflation drop substantially from its current levels. Since unemployment remains at very low levels, there is little (barring a liquidity crisis) to stop the Fed from continuing on this path.
Elevated interest rates negatively impact credit-dependent businesses as well as stock/bond markets. They also impact public finances, since governments of all sizes have to pay more to borrow. Corporate borrowers also spend more on servicing debt, and marginally profitable projects get shelved when the cost of financing them rises. Consumers are also hurt as mortgages, auto loans and revolving credit lines become more costly, thus curtailing spending. All of this impacts corporate earnings, which will almost certainly drop from cyclical highs as the impact of rate rises is felt across industry.
In addition to inflation, we see several other signs to discourage aggressive risk taking. We have begun to see early indications of a drop in business activity. Certain US sectors such as real-estate, which are particularly credit dependent have slowed dramatically. US Job postings have dropped precipitously, though there continue to be far more job openings than in prior years. The IMF(International Monetary Fund) published a report indicating they now expect a global recession in 2023. The IMF’s Global Financial Stability Report indicates that the stability of global financial markets has “materially worsened” and markets face a higher likelihood of “disorderly pricing”. The US Treasury publishes an indicator of financial stress, which has been rising (albeit from very low levels) over the past few weeks. All of these indicators combine to raise risks for investors.
The lack of clarity around inflation as well as the potential for the Fed’s response to drive the economy toward recession has resulted in substantial selling in both stock and bond markets, with the bond market (through the first three quarters) posting one of its worst years on record. We expect to see continued volatility in both markets until investors see
definitive data suggesting a cooling of inflation and/or a pause/reversal of the Fed’s interest rate policy. If and when markets see a shift in policy, we expect stocks and bonds will rally sharply. However, there remains the risk that elevated inflation could become entrenched (which the Fed is aggressively fighting), in which case stocks and bonds would likely remain under pressure.
While market volatility can resemble a dizzying roller coaster ride, it often comes with opportunity. Bear markets can cause investors to act impulsively and sell assets indiscriminately in response to short term market conditions, without considering the long term. This leads to quality assets priced at discounted levels, levels much lower than an investor would typically find during a bull market. We continue to recommend a defensive allocation (due to the risks outlined above), but with an eye towards shifting money towards risk assets as prices fall further and entry points become compelling. Our long term outlook for the global economy remains positive and we expect patient investors will be rewarded.
Let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

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