Special Market Update 06/17/2022
/The Federal Reserve has announced an interest rate hike of 0.75% to the fed funds rate following their June meeting. This decision was in response to persistently high inflation data and was widely expected. The Fed is now predicting at least three more 50 basis point increases and one 25 basis point increase by year's end, which would put the Fed Funds rate at 3.40%. They also see rates at 3.8% by the end of 2023. And oddly, they suggested they may cut rates by 25 basis points in 2024.
The Fed also updated their inflation forecast, putting the PCE Index at 5.2% by the end of 2022, which is up from their previous estimate of 4.3%. But then they see inflation falling to 2.6% in 2023, and then 2.2% in 2024. As for growth, they see GDP at 1.7% for full-year 2022, which is down from their previous estimate of 2.8%. They also see GDP at 1.7% for 2023, then 1.9% for 2024.
Initially, the equity markets rallied on the news as investors signaled their support for the Fed’s tougher response to runaway inflation. Unfortunately, the selling pressure returned just a day later as investors weighed a wide range of indicators suggesting a more rapid deceleration in the U.S. economy could be developing.
We want to acknowledge that this is an exceedingly difficult period for our clients, just as it is for us. We utilize the same strategies for our personal assets as we do for our clients. Accordingly, we feel the same frustration and concern that all our clients share during such times of stress.
Balanced portfolios, those generally defined as having an asset allocation known as 60/40 (60% equities and 40% bonds) have experienced a drawdown of about 17% to 19% year-to-date. This represents the second-worst six-month drawdown in at least 50 years. Normally, bonds provide some sort of support when equity prices are falling, but that hasn’t been the case this year. Bonds have on average delivered -11.7% total returns this year, adding to - and arguably causing - the collapse in equity prices rather than offsetting the bear market in equities.
That said, for the first five months of the year a rational case could be made that key measures of the economy indicated continued growth. This continues to be the case. At the moment, the preponderance of evidence would point to continued, if modest, economic growth. Over the past several weeks, however we have seen a shift in the data.
Both the Empire and Philly Fed regional manufacturing reports not only came in weaker than expected, but they showed contraction at the headline level. Retail Sales missed estimates. Housing starts and building permits also widely missed consensus forecasts with starts showing the largest month over month decline since early 2015. Lastly, both initial and continuing Jobless claims came in higher than expected.
The Atlanta Fed has developed a near real time model to estimate current quarter economic activity. Just this week their model was updated showing a 0.0% growth estimate for the second quarter, just as most economists were still forecasting growth closer to 3% on average. Who is right? Well, we won’t know for sure until the Q2 number is finalized, but we do know that activity is slowing more rapidly than was originally expected.
Does all of this change the odds for a recession this year? In a word, yes. While we had not believed it likely a recession would hit the U.S. economy in 2022, we recognize how quickly the data is shifting. And as we have always promised, when the facts change so would our perspective and forecasts. The odds of a recession happening sooner than we expected are increasing and our attention must turn to accessing the implications a recession might have on our investment strategies.
Not all recessions are the same. Some are quite deep and lengthy, while others are relatively short and shallow. In fact, a minor recession at this time could reset the U.S. economy and greatly reduce the rate of inflation. At this time, we believe a rational case can be made that any recession in 2022 would be relatively brief as consumer balance sheets remain strong, the economy is still in the process of reopening following COVID, and there remains a large degree of pent-up demand.
Recessions are typically thought of as two straight quarters of negative GDP, criteria which the current period is now looking increasingly likely to meet. The actual definition used by the National Bureau of Economic Research (NBER) is more nuanced, though. According to the NBER, a recession is defined as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months. The committee's view is that while each of the three criteria—depth, diffusion, and duration—needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another.”
This said, whether or not the government officials classify the first six months of this year as a recession is more a question of semantics than anything else. The classification of start and end dates for recessions are typically made several months after the fact, and in many cases, when the start date of the recession is made official, the trough (for both the economy and the stock market) has already been reached.
If a recession is inevitable at this point, from an investor's perspective, given that markets are forward-looking and down dramatically already, it's probably better if we're already six months into one rather than just on the precipice. We'd hate to imagine how much farther the market must fall if indices are already down 20-30% and are not yet even pricing in a recession.
So, what does all this mean for investment strategy? There have been 14 bear markets since World War II and there is a great deal of data from those different downturns to consider. The table below helps us see how long it took for equities to recover losses and the different performance thresholds achieved 3, 6, and 12 months following these bear markets.
This data would suggest that additional price weakness may be ahead with the average drawdown historically running about -32% (the S&P 500 is down approximately 23% at the time of this writing). This data also indicates that equity prices are, on average, approximately 18% higher a year later.
All bear markets are painful and there is a natural urge that nearly all investors have to “do something” to stop the pain. For most, this translates into a desire to get out of the market until the smoke clears and it feels better to put monies back to work. We understand this urge, however making short-term damage permanent is often a poor long-term choice as it requires investors have the fortitude to buy back positions just as the market reaches a bottom. Importantly, markets don’t bottom on good news.
This is exceedingly difficult to do. Between 2002 and 2021 (roughly 5,100 trading days), the S&P 500 delivered an average annual return of 9.5%. Nearly 85% of the best days occurred immediately following the worst days. If an investor were to miss only the 10 best days (roughly 0.2% of the trading days), their average annual return would have dropped to 5.3%. If they had missed the 30 best days (roughly 0.6% of the trading days), their average annual return would have dropped to 0.4%.
As the Wall Street adage reminds us, investors should buy when everyone else is selling and sell when everyone else is buying. As with many things, this is one that is easier said than done. Money involves emotion and emotions can be difficult to resist, especially when circumstances reach extreme levels. We are well served by reminding ourselves that bad times follow good times and good times follow bad. This current downturn will eventually end, and the markets will stabilize. Ultimately, a new bull market will emerge, and new record highs will be achieved. History would also suggest this will happen much sooner than many people think possible as the painful part of the cycle is at hand.
There are plenty of positives in the economy that have been virtually ignored during this sell-off, including a strong labor market (near 50-year low unemployment), strong household spending, strong business investment, strong corporate earnings, and strong industrial production. We constantly hear and see how stores and restaurants remain crowded, planes are full, and retail sales continue to show year over year increases.
In conclusion, things could get worse before they get better – but they will get better. Successful investing is a process of ups and downs, while wealth is created and maintained over time with occasional setbacks. Volatility is the price investors must pay for attractive long-term performance.
Thank you for your continued confidence, especially during times of stress. Please feel free to reach out directly to us if you have additional questions, or should you wish to discuss our perspectives in greater detail.
John E. Chapman
Chief Executive Officer
Chief Investment Strategist
