Macroeconomic View & Markets
Throughout 2022, the broad market selloff and the aggressive Federal Reserve rate hikes have been prominent in the news. The question is when will both stop. I will address both below with the market selloff on the next page.
The Fed is an independent government agency that has two macroeconomic objectives set by Congress that guide all of their decisions. The objectives are referred to as their dual mandate, which is to provide stable prices and maximum employment. The Fed’s goal is to create an economic environment that leads to stable prices for the goods and services we consume, while still having full employment. The Fed is trying to create low (not zero) inflation and low unemployment. We have the low unemployment. We now need the low inflation. As we have discussed in our post-pandemic Commentaries, there has been too much money chasing too few goods. Suddenly, in late 2021, the economy went from virtually no inflation in 2020 to the worst inflationary environment since the late 1970s.
The Fed is deliberately slowing the U.S. economy by raising interest rates to combat inflation. The Fed believed inflation would moderate as businesses reopened from the global pandemic shutdown. They lost that bet. Pent-up consumer demand collided with global supply chain shutdowns, drought, and war that created drastic supply shortages and delivery delays. As demand outstripped supply, prices have risen much faster than expected.
To reverse that climb, the Fed has had to raise interest rates (Fed Funds Rate) in an attempt to slow our spending. Those increases, a total of 3.0% from near zero for 2 years (March 2020-March 2022), appear to be working. In June, the Consumer Price Index peaked at 9.1%. It remains elevated but did fall to 8.2% in September. The Fed’s preferred Core Personal Consumption Expenditures Price Index of inflation excludes highly volatile food and energy prices and has been gradually decreasing to a current 4.9% in August. Housing and used car price are also slowing. Though trending down, the inflation drop will not be linear. The impact the Fed seeks in the economy from interest rate hikes unfortunately takes a lot of time (9 months to 2 years) to show up. Until the Fed sees that inflation is consistently declining and consumer demand moderates, we expect them to continue to raise rates.
The current unemployment rate remains at the July low of 3.5%, an indicator of a strong economy. A tight labor market means higher wages, which pushes up inflation. However, another positive sign of rising rates is that the number of job openings decreased to 10.1 million in August after peaking at 11.9 million in March. Jobless claims continue to be near historic lows but are trending higher as businesses begin to cut expenses, including layoffs. Although the latest Atlanta Fed GDPNow estimates third quarter GDP at a still-healthy annualized 2.9%, the business hiring slowdown should moderate wage inflation.
Unfortunately, a side effect of raising borrowing rates to cool demand is slowing consumer demand so much that a recession might occur. The Fed has a tough balancing act, moving us from “too hot” but not into “too cold.” Getting it “just right” in this persistent strong economy is challenging.
It definitely has been a very difficult year watching both stock and bond returns drop into the red. Diversification has not helped portfolios. The only way to have avoided these negative returns was to have completely cashed out. Getting that timing correct is virtually impossible. Throughout the year, we have been defensively positioned. We are underweight bonds and equities. The equities we own are tilted towards “value,” which outperform “growth stocks” in a rising rate environment. We are significantly overweight cash and alternatives, which in this reversal continue to outperform both bonds and stocks.
As a reminder, the markets move ahead of the economy. Stocks and bonds anticipate what the economy is expected to do. So, the market downturn this year reflects the anticipation by the buyers and sellers of securities that interest rates will rise and the global economy will slow its pace of growth and shrink. Volatility is very high as uncertainty builds about an end to the overheated economy and aggressive Fed rate hikes. Year-to-date, approximately 50% of all trading days (S&P 500) have experienced daily movements of +/- 1%, and approximately 20% of all trading days of +/- 2%.
Since January, equity markets have been in a cyclical bear market. This is a result of elevated inflation and a deceleration of economic growth, which is tied to a business cycle of higher rates. These declines average about 30% and persist slightly over a year. Based on the historical averages, the current market appears much closer to the bottom.
Fixed Income: cash led for the quarter, 1, and 3-years, while high-yield corporates led in all other periods. The U.S. Aggregate Bond Index was the laggard for the quarter, 1, 3, and 5-years, while cash was the worst performer for the past 10 and 15-years.
Equities: small U.S. stocks led for the quarter, while large-cap led in all other periods. Real estate was the worst performer for the quarter, while foreign was the laggard in all other periods.
Let me reiterate: Stock prices reflect what is expected to happen, not what is currently happening in the economy. Over the past 30 years, the S&P 500 has generated approximately 10% in annualized returns for those who remained fully invested, took no withdrawals and did not add during the period. These 30 years experienced seven bear markets. The market always comes back from its declines stronger, and new highs will eventually replace the old ones. We will remain patient and diligent.