Why investors should consider a more defensive approach in Q4

As of Oct. 17, 2022

Cleveland Federal Reserve President Loretta Mester encapsulated the tone of September and the third quarter best when she said in a speech, "a recession won't stop the Fed from raising rates."

Marked by stickier-than-expected inflation, tightening monetary policy and slower economic growth, the third quarter was another volatile one for stocks and bonds. Likewise, quarter four isn’t shaping up to be much calmer.

As we enter the last quarter of a challenging year, here are the key takeaways from Q3, what to watch for in Q4 and how investors can position themselves for a likely volatile end to 2022. 

What were the key developments in Q3?

  • Federal officials reinforced their hawkish stance, expressing 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).
  • The S&P 500® Index posted its worst September in 20 years and its worst month of performance since March 2020. In September, the S&P 500 and NASDAQ fell for the second straight month, falling 9.3% and 10.5%, respectively. The NASDAQ also saw its worst month since April and its second-worst month since 2008. Unfortunately, the story wasn't much different for the quarter: U.S. equities were again lower for a third straight quarter, with the S&P 500 finishing Q3 down 5.3% and the NASDAQ off 4.1%.
  • 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 a disheartening development for investors hoping markets had sailed through the worst of the storms. With the S&P 500 off nearly 24% through the first nine months of the year, the U.S. stock benchmark suffered its third-worst performance at that point in the year since 1931, according to Bloomberg.
  • The yield curve hit its most inverted level this century. And while bonds have helped mitigate declines versus an all-stock portfolio this year, the Blomberg Universal Bond Index declined 14.9% year-to-date through September, one of its worst years in decades. 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 U.S. Dollar Index posted its fifth straight quarter of gains and its largest move since Q1 2015. On the other hand, West Texas Intermediate (WTI) crude dropped nearly 25% in Q3 on weaker global growth and heightened recession fears, while Gold ended down 7.5%.

What to watch for in Q4

Looking ahead to year-end, 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.

In addition, earnings estimates for next year are too high, in our view. 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 third quarter earnings season starting this month to be a critical gauge in shaping how analysts adjust their profit forecasts for the next few quarters. Items that will be closely watched across industries will likely center on results/outlooks tied to the demand backdrop, input costs, profit margins, labor conditions, and currency effects. Bottom line: The third quarter earnings season could create added volatility for stocks if analysts are forced to reduce profit outlooks for the coming quarters.

Notably, Fed officials will look for signs that labor conditions are cooling in the fourth quarter, which is expected to help bring down wage inflation. However, September nonfarm payrolls rose by +263K, while the unemployment rate fell to 3.5% (matching a 50-year low). Moreover, employment growth last month was broad-based. Several industries, including in health care, leisure/hospitality, and construction, added jobs in September. And while wage inflation moderated from August levels on a year-over-year basis, tight labor conditions continue to keep upward pressures on hourly earnings. As a result of a still-strong labor market, the Federal Reserve is very likely to keep pressing rates aggressively higher this year. We believe this could continue to create headwinds for asset prices in the fourth quarter.

5 ways investors can position themselves for a (likely) volatile Q4

To help reduce the potential for continued volatility in the fourth quarter, investors should work with their Ameriprise financial advisor to consider incorporating the following strategies into their portfolio:

1. Lean on defensive strategies

At a high level, this includes favoring U.S. assets over international investments, utilizing alternative strategies to potentially reduce equity volatility, and favoring value stocks versus growth stocks. Notably, investors should temper return expectations and expect a more volatile market environment until inflation pressures moderate and central bankers stop raising interest rates.

2. Balance U.S. sector exposure

We believe defensive sectors of the economy should be balanced with growth opportunities – particularly those with solid fundamentals, stable growth prospects, and attractive valuation levels. For example, sectors such as consumer staples and health care can act defensively when stocks are falling, while financials and technology can offer growth opportunities when markets begin to recover.

3. Keep the focus on the U.S.

In times of elevated uncertainty, a domestic bias can reduce risk. A relatively healthy financial condition across U.S. consumers/businesses are factors that could help the U.S. outperform international areas, such as Europe and emerging markets.

4. Don't forget about fixed income

The backup in rates this year has created greater opportunities to generate income from your bond portfolio. Focus credit exposure on shorter-term durations and high-quality investments. With the recent backup in yields, investors can generate a competitive return on shorter-term bonds with reduced risk relative to stocks and long-dated bonds.

5. Expand your investment horizon

Many alternative strategies can contribute to a diversified portfolio and help mitigate some of the risks in more traditional assets, like stocks and bonds. Strategies that reduce equity volatility or seek a real (after inflation) return may offer a prudent way to manage through added volatility and stay prepared for the unexpected.

Bottom line

In our view, investors should continue to lean on diversification, favor high-quality assets, and recognize security selection could play a more prominent role in generating returns in the fourth quarter and beyond. However, long-term opportunities will eventually present themselves to patient investors.

Our advice: Plan to weather more storms, avoid timing mistakes, focus on what you can control and reach out to your Ameriprise financial advisor if you have concerns or questions. The one thing all bear markets have in common is that they eventually end.

Data sources for indices and sector graphs: Morningstar Direct, as of Oct. 4, 2022

Past performance is not a guarantee of future results.