THE SHORT STORY
The market has been humbled so far this year by ongoing inflation concerns and the Federal Reserve’s response. Volatility should continue as the market reacts to corporate earnings falling short of the record-setting year that Wall Street is currently forecasting due to margin pressures.
All that said, we do not see things as being overly dire. The economic backdrop is very strong and should allow us to weather impacts from the Fed’s actions, inflation, and any economic hiccups in a resilient manner.
While we cannot predict when, exactly, the market will bottom (studies show that trying to do so is futile), there is a great case to be made that we are at, or at least near, a great market entry point. To quote Warren Buffett, “Be fearful when others are greedy, and greedy when others are fearful.”
Where We’ve Been – 2022 Q2 Review
Markets have been turbulent thus far this year. Excessive stimulus and supply chain issues stemming from Covid both stunted supply and turbo charged demand – a recipe for inflation. Wary of upsetting the market’s apple cart, the Federal Reserve started talking about rate hikes in Q3 2021 but did not actually get around to acting until March 2022, when it was already painfully obvious that inflation was not “transitory”.
When the Fed began signaling to markets in January 2022 that it intended to hike rates higher and faster than it had initially indicated, markets repriced downwards – and quickly. The inverse relationship that bonds have with interest rates sent bonds plummeting. Stocks took a nosedive as well, given that the discount factor used to value stocks is derived from interest rates (and a higher discount factor = lower valuations/prices).
Since rate hikes began, the world has been somewhat upside down, with good economic news being bad for markets (strong economic data gives the Fed more cover to hike rates, implying “more damage to come”), and bad economic news being good for markets (bad economic data indicates the Fed may stop tightening, implying “damage has already been done”). Of course, the Russia-Ukraine conflict has only served to exacerbate the inflationary issues facing the Fed (and increase market fears that the Fed will hike the economy into a recession).
Second quarter and year-to-date returns, as shown below, are sharply negative outside of the US Dollar, which has benefitted from the Federal Reserve raising rates faster than other central banks around the world, and the fact that the economic recovery in the US has been stronger than that of other international economies.
|Market Category||Market Index||Q2 2022||YTD 2022|
|US Large Cap||S&P 500||-16.1%||-20.0%|
|US Small Cap||Russell 2000||-17.5%||-23.9%|
|International Developed||MSCI EAFE||-14.3%||-19.3%|
|Emerging Markets||MSCI Emerging Markets||-11.4%||-17.6%|
|US Bonds||BB US Aggregate||-4.7%||-10.3%|
Where We’re Going – 2022 Q3 Outlook
The cat and mouse game that the Fed is playing with inflation will continue to impact markets. As part of this, the artificial volatility suppressing distortion that the Federal Reserve has created in markets for the last ~15 years will begin to revert, ultimately making a case for a new normal of higher volatility.
Aside from the Fed, we expect corporate earnings to start to play a bigger role in market returns. Current expectations are for record earnings this year and next year. Faced with rising input costs, wage pressures, and waning economic stimulus, achieving record earnings seems unlikely. Headlines are already showing signs of stress – layoffs, hiring freezes, inventory build ups, strong dollar, etc. Ultimately, we expect profits to be positive, but to fall short of expectations (or for analyst expectations to be adjusted downward). When markets digest the reality of this, there could be more downside volatility.
Despite this gloomy outlook, and the fact that we are likely already in a technical recession (two quarters of economic contraction), we do not see things as being overly dire. The consumer is strong (excess savings, strong labor market), corporate balance sheets are relatively unlevered, and the overall economic backdrop is healthy (albeit slowing). Given this, we believe that any recession will prove to be mild and have relatively benign effects on the average individual. Because the recessions that people remember are the more severe ones, it is often forgotten that recessions are a normal (dare we say “healthy”) part of the economic cycle…growing, getting rid of excess, and repeating….
While we cannot predict when the market will bottom (studies show that trying to do so is futile), there is a great case to be made that go forward returns will be strong.
- Valuations have moderated substantially, improving go forward return expectations
- Historically, large drawdowns are followed by periods of strong returns
- Consumer Sentiment, a contrarian indicator, is at 40-year low
- Markets bottom before economies bottom, and peak before economies peak
- Cash on the sidelines is losing badly to inflation in this environment
Although we are at or near a great entry point to invest, there remains much uncertainty in markets. Therefore, it is important to emphasize that our main conviction is that market exposure today should be rewarded over the next 1-2 years. Because of the remaining uncertainty, we are focused on attaining exposure through allocations in more defensive areas of the market that will be more resilient through remaining volatility while still offering very attractive upside potential when the bear market ends.
Thank you for allowing us to partner with you as we navigate the ever-changing market. We appreciate your continued trust.
If you have questions or would like to dive deeper into this quarter’s outlook, please reach out to our investment team. We’d be happy to set up a virtual coffee to talk more.
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