by Brad M. Weafer, CFA | Chief Investment Officer
Key Points
- Persistent inflation has pressured policymakers into the largest and fastest set of interest rate increases in over 40 years.
- That shift in policy weighs on the valuations of all financial assets and is threatening to press the U.S. economy into recession.
- Despite the negative backdrop for risk, historically equities have often rebounded within 12 months of a 20% decline.
With the increased volatility experienced throughout the global capital markets over the past few weeks, I wanted to send a brief update on our thoughts regarding this turbulence. Seeing the market decline dramatically over such a short period can test the resolve of investors, and we know that these drawdowns are immensely stressful. In thinking about the financial markets in 2022, “pressure” is the first word that comes to mind.
Inflationary Pressure
In the aftermath of the Covid-19 pandemic, the globe is experiencing inflationary pressures not seen since the days of Jimmy Carter and Paul Volcker. After too much time at home, significant pent-up demand has been unleashed and excessive fiscal stimulus fueled the rush to spend. On the supply side, pandemic-related disruptions created shortages in a host of goods ranging from new automobiles to baby formula. Just when it seemed things were starting to normalize, the Omicron variant caused significant absenteeism to a labor force already short on workers. If that wasn’t enough, geopolitical tensions flared after Russian forces invaded Ukraine. Both nations are major sources of global commodities, fueling the inflation problem even more. With job openings outnumbering job recruits, wages have marched higher, supporting persistent inflation challenges.
Policy Pressure
Pressure is also the right word to describe what monetary policymakers are feeling. For most of 2021, Central Bank officials advocated that inflation was transitory and left policy unchanged. That has changed dramatically in 2022. With inflation proving more persistent, policymakers have reacted by raising interest rates. Last week, the Federal Reserve (Fed) raised the target range for the federal funds rate to 3% – 3.25%. Coupled with actions since the start of the year, rates have increased at a material and rapid pace (see chart below for context), exceeding anything we have seen since the early 1980s. The price of any financial asset (including bonds and stocks) is inversely influenced by interest rates. Thus, as interest rates rise traditional assets have all felt the gravitational force of this pressure.
Figure 1: 40-year history of Fed Rate Hiking cycles
Note: Data is short-term interest rate targeted by the Federal Reserve’s Federal Open Market Committee (FOMC) as part of its monetary policy. Source: Bloomberg, Federal Funds Target Rate – Upper Bound (FDTR Index), using monthly data. Past performance is no guarantee of future results.
Source: Schwab
Earnings Pressure
Inflation is a clear problem, and the cure isn’t painless. Policymakers are faced with the difficult choice of trading slower economic growth for more benign price increases. Rate increases raise financing costs for businesses and consumers, ultimately slowing end demand. We have already seen evidence that policy changes are having an effect. The Leading Economic Indicator series reported by the U.S. Conference Board has fallen for six consecutive months and in seven of the last eight. This rarely happens outside of economic recessions. Inflation, while still high, has shown signs of peaking, a prime example being gas prices falling throughout the summer. Unfortunately, any hope that policy would shift with these signs was dashed last week following the release of the Fed’s September policy statement.
Commentary about future rate increases suggests policymakers are willing to risk recession to slow inflation. Fearing a repeat of the errors of then Fed Chairman Arthur Burns in the 1970s, current Chairman Jerome Powell’s public comments remain resolute. The intention is clear; the Fed will raise rates until inflation shows meaningful declines, and it is willing to tolerate economic weakness to achieve that. Further weakness would certainly put downward pressure on corporate profits.
The combination of slowing economic growth stressing earnings forecasts and higher interest rates weighing on equity valuations is a bad combination for stocks. Stock markets globally reacted in an understandable fashion. The S&P fell over 5% in response as of this writing (Monday morning) following the Fed’s announcement.
Time
Geology is the study of pressure and time¹. In that metamorphic process, over long enough periods what looks like rubble can transform into gems. We see obvious parallels to investing and benefits that accrue to patience and resolve.
Drawdowns in equity markets put emotional pressure on investors. When this happens, many are quick to point out why prospects for the future are bleak. The obvious negative news of the day (like inflation and recession risk) gets extrapolated, and markets tend to overshoot. The S&P 500 index is down over 20% from highs reached in early January, nearly reaching the low point previously seen in June. This marks only the 18th time the S&P has fallen by 20% from a previous high in the post-war period. What can we learn from those 18 experiences? Not falling victim to panic pays dividends. In only half of those instances did stocks fall more than 2% further. The median decline of all market declines of 20% or more is 26%, meaning much of the damage may have already been done. Extending the time frame is instructive. Stocks were higher a year later 82% of the prior 17 instances (see Figure 2 on the next page). Three years later, stocks were higher in all but one instance and returned on average 15% a year over that period, well-above historical average stock market returns.
Figure 2: History of 20% declines in the S&P 500 Index
Source: Bloomberg, BFM Estimates
Naysayers will point to the Great Financial Crisis for what could happen. There is no disputing that things could get worse. But even the horrible returns experienced then were rectified with time. Consider that had an investor bought stocks at the prior peak in 2007, they would have earned a 10-year annualized return of over 7% by 2017. We do not mean to minimize the challenge of living through declines, but it is instructive to recognize how challenging it is to pick the absolute bottom in stock indices. Historically, stocks improve ahead of economic activity. The National Bureau of Economic Research (NBER) is charged with dating U.S. economic recessions. A review of history suggests major indices bottom 3 to 6 months ahead of the official end dates of recessions, long before it is obvious. So despite the challenging outlook of today, history suggests that the equity market typically rebounds within 12 months of a 20% decline.
Our management team has been meeting regularly to discuss the positioning of our portfolios, and we will continue to do so throughout this period of elevated volatility. I have had the privilege of speaking with many of our clients over the past several weeks, and our Wealth Managers and I welcome these discussions. Please reach out to your Wealth Manager or to me at any time. Thank you for your continued confidence.
¹Hat tip for this quote to the fictional character Red, in the movie Shawshank Redemption