Wealth Matters Newsletter - July 2022

Investing is a long-term endeavor, marked by periods of appreciation and decline, stability and volatility.  Over the last couple of years, investors have been exposed to some of the most challenging and rewarding periods we’ve seen in the last decade.  Most recently, we are reminded that investing presents challenges, with the S&P 500 having completed one of the worst starts to the year in decades.  In fact, most major asset classes, excluding commodities and real estate, have exhibited negative returns through June 30, 2022.  Even gold, which has historically been viewed as a store of value and an inflation hedge, experienced a decline.  The declines across asset classes this year is attributable to one factor, in our opinion: global central banks, led by the U.S. Federal Reserve, removing liquidity from the global economy.

Over the course of 2022, the U.S. Federal Reserve has raised the Fed Funds target rate from 0.0%-0.25% to 1.5-1.75%, including a 0.75% rate increase at its June meeting.  Markets are also currently forecasting a 0.75% increase at the Fed’s July meeting, and 0.50% increase at its September meeting.  Fed Chair Jay Powell has made it clear that the Federal Reserve is resolute in its fight against inflation, and will remain data-dependent in its assessment of economic conditions and the need to adjust monetary policy.  Unless there is a material downshift in inflation readings in the next two months (an unlikely scenario in our opinion), then there is no reason to believe the Fed is likely to change course.  The Fed is attempting to engineer a “soft landing” – a slowing of economic growth sufficient to curb inflation without causing a recession – but we believe the probability of success is low.  That does not mean that a Fed-induced recession will be severe; we could experience a “technical recession” where the economy experiences two consecutive quarters of negative GDP (gross domestic product) growth with marginal overall impact.  U.S. GDP in the first quarter of 2022 was -1.6%; economic indicators reported throughout the second quarter indicate a possibility of a negative GDP print, which would match the textbook definition of a recession.  The Federal Reserve Bank of Atlanta’s GDPNow forecasting model, which provides a real-time estimate of GDP, generated an estimate of -2.1% for the second quarter.

Unemployment remains near historic lows, so perhaps a “shallow” recession is what is needed to help tame inflation.  High prices have already had some mild impact on consumption, as noted by executives at Target and Walmart during the second quarter.  If we are headed for recession, what should investors expect of markets?

Bear markets, as defined by a 20% or greater decline from a recent high, are not uncommon.  Since 1929, the S&P 500 has experienced fourteen such occurrences; eleven of those also associated with a recession.  The table below from BNY Mellon Investment Management provides some historical context.

Perhaps the most important information to glean from this table are the market return statistics on the right side of the table.  These data depict the forward returns of the S&P 500 after entering a bear market, with the majority of instances showing a positive cumulative return after three years.  The Volker Bear market may be most interesting comparison to today’s markets given the potential similarities.  Paul Volker was the Federal Reserve Chair who was charged with taming in the high inflation experienced in the late 1970’s.  Under his direction, the Fed Funds rate was increased dramatically, triggering a recession, but ultimately bringing inflation down with it.  It is unlikely today’s Federal Reserve under Jay Powell would engage in similar dramatic policy moves as executed by Volker, but larger magnitude interest rate policy changes like we witnessed in June are still obviously affecting markets and the economy.  Given the decline in markets, investors have already priced-in a significant amount of bad news, in our opinion, but it is unlikely that we have seen the lows for this particular cycle.

As the table illustrates, bear markets rarely bottom out when the -20% threshold is crossed, so if this bear market follows similar form, we see more downside risk in the markets in the near-term.  Analyst expectations for corporate earnings over the next twelve months is likely too optimistic, given the budget pressures consumers are facing and the likelihood that those pressures will not be resolved in the next several months.  Food and energy prices remain high and supply chains are still clogged.  Inflation is the thorn in the side of consumers, producers, and investors and until we see progress in the fight to get inflation under control, markets will likely to continue their challenging grind in the near term.  Over the medium term and long-term, we remain optimistic.  We will continue to use these challenging market conditions to reallocate and position for the opportunities these conditions create.