Capital markets this year have been unkind to investors, to understate the case. While the speculative and more “growthy” areas of the market (which our investment approach seeks to avoid) have seen the most damage, there has been nowhere to hide as all major asset classes and equity indices have experienced significant declines after 18 months of largely uninterrupted gains in the 18 months following the 2020 pandemic sell off.
The primary factor in the current market weakness is a re-pricing of assets due to rising interest rates as the Fed has embarked on a path of monetary policy tightening in response to inflation. Most companies are reporting growing earnings, but the multiples of earnings that investors are willing to pay has declined in response to higher rates and to concerns about the outlook for the economy. The war in Ukraine and continuing lockdowns in China have not helped either inflation or investor confidence.
In past rate rise cycles, markets have generally been volatile and down-trending in the several months before and after the initial rate hikes – a pattern that is repeating this year around the initial hike in March. How the markets do in the six to 24 months following start of rate hikes depends largely on how inflation and the economy respond. Markets want a “soft landing” in which inflation declines before the Fed raises rates to the point where the economy enters recession.
The Fed has been proven wrong in its 2021 view that inflation would be largely transitory. That said, there are a number of solid reasons to believe that inflation is peaking and the rate of change will soon begin declining. These include baseline effects, easing supply-chain bottlenecks, and a shift away from consumption of goods (which have had a higher rate of inflation) back towards services for which inflation has been lower. More difficult to forecast is how fast inflation declines which will drive the Fed’s decisions on rate hikes. One of the Fed’s biggest challenges is housing as shelter costs make up about a third of the CPI. Home prices have been rising 20% year-over year, and rent costs follow home price trends.
As to whether we see a recession, our views track with those of Goldman Sachs economists who put the odds of a recession in the next 24 months at 35%1. Signals from the yield curve, Leading Economic Indicators, and PMIs are not saying recession. Goldman notes that the tight labor market gives the Fed room to tighten to where companies shelf some expansion and hiring plans, but don’t have to lay off workers and slash output. Second, they cite strong consumer balance sheets and cash levels giving consumers capacity to keep spending even if job and income prospects weaken some. And lastly, while monetary policy is clearly tightening, it is still not tight.
Markets hate uncertainty and for now, uncertainty is high. Recent readings from the American Association of Individual Investors Bullish-Bearish survey are at the third most bearish extent in 35 years and are now below their readings at the bottom of the markets during COVID2. However, excessive bearish sentiment has historically augured bullish, working as a counter-indicator to forward market performance. For markets to gain a solid footing, we think we will need to see inflation readings that suggest that Fed tightening will be less than what the market has priced in. Right now, it is difficult to forecast how long this will take.
So what to do now? Our preference for higher quality companies with solid balance sheets and business models is favored by challenging environments such as we are experiencing. Hence, we haven’t felt a need for major portfolio revisions, especially given the embedded unrealized gains in taxable accounts that have enjoyed the appreciation of recent years. That said, the market decline does afford opportunities for some switches to higher quality areas of the market and for tax-loss harvesting.
While we have always over-weighted U.S. equities relative to the rest of the world, coming into the year we thought this might be the year in which non-U.S stocks would benefit from their lower valuations and prospects for “catch-up” growth. Between the war in Ukraine and persistent pandemic effects abroad, especially in China, the U.S. has continued to lead, albeit not by as much as in recent years. Hence, some trimming of non-U.S. holdings could be appropriate in some accounts.
In investing there is no free lunch. The price that investors pay for the attractive returns that equities have generated over time is volatility and drawdowns such as we are now experiencing. While asset allocations must always be appropriate to individual objectives and risk tolerances, and tactical changes can be helpful, for long-term investors the correct strategy for responding to market periods such as the present has been to ride out the downturns and be rewarded when healthier markets return. Reactionary changes in down markets can negatively impact long-term returns.
Please reach out to us if you have questions or concerns about our thoughts here or about your accounts.
1GoldmanSachs.com. “Will the U.S. Go Into Recession,” April 19, 2022.
2American Association of Individual Investors, AAII.com, “AAII Sentiment Survey: Highest Level of Pessimism Since March 2009,“ April 27, 2022.
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