The reigniting of inflation to its highest levels in over four decades has been the catalyst
for the dramatic sell-off in stock and bond markets for the past year. Inflationary pressures
began building in early 2021 as the result of several factors: revived consumer demand in the
aftermath of the COVID shutdowns; supply chain disruptions from multiple sources; and the
excessive monetary and fiscal stimulus from multiple COVID rescue plans implemented by
the Federal Reserve and the Federal government.
In its effort to fight inflation, the Fed
raised interest rates five times so far
this year, including not one, but three
rate hikes of 75 basis points each, for
a total increase of three-percentage
points on the Fed Funds rate – the
overnight lending rate for banks. And
with inflation running hot at over
8% annualized, the Fed has clearly
signaled that it isn’t done yet. Indeed,
with interest rates having started
the year near zero, the Fed indicated that it may push its Fed Funds target up another 1.25
percentage points to about 4.5% by year-end, and possibly higher. Meanwhile, short- and long-term
interest rates began a game of “catch up,” as bond investors demanded higher yields
on fixed income assets to compensate themselves for the prospect of higher and sustained
inflation. Yields on the shortest maturities have risen most, with 2-year Treasuries yielding
more than 4% at the time of this writing.
Many analysts expected a temporary, post-COVID jump in inflation, due to pent-up demand and a normalizing of prices
following the brief deflation during COVID (recall that many prices fell as consumption collapsed in early 2020). However, the
ongoing shutdowns of overseas economies (particularly in China) have extended and worsened supply chain disruptions,
as has an unusual decline in labor supply as many workers have effectively quit the labor force, creating bottlenecks and
backlogs everywhere from restaurants to commercial shipping ports. Meanwhile, a different kind of supply disruption was
created by curtailed US oil and gas production and embargoed Russian energy supply – a global sanction for that country’s
war on Ukraine. The resulting surge in energy prices further “fueled” inflation by raising the costs of production throughout
the supply chain, from transportation to the fertilizer needed to grow global crops. Grain production was another tragic
casualty of the war in Europe, resulting in a troubling food shortage that has also had global and inflationary consequences.
It has been rightly said that inflation can be described as the result of too much money chasing too few goods. Fiscal and
monetary policy injected trillions of dollars into the US economy during the COVID crisis, and the Fed’s newfound monetary
retrenchment may help with that source of rising prices, but it can’t resolve the supply issues resulting from other factors like
war, regulatory restrictions, and lifestyle changes. Most of these may still prove to be temporary, though painfully prolonged.
However, the Fed’s aggressive rate hikes have produced something else: a bear market in stocks. As the Fed pushes interest
rates higher, the likelihood of an economic recession also grows. By traditional measures, the US economy was officially
in recession after two quarters of contracting gross
domestic product (GDP) during the first half of the year.
GDP performance for the third quarter is uncertain, but
many analysts expect it to be soft at best. Nevertheless,
unemployment remains remarkably low at 3.5% and business
hiring remains relatively strong, though much slower than
at the start of the year – likely a product of the unusually
low labor force participation rate. Still, a weak economy
translates into lower profits – a direct reduction of one of the
key factors supporting stock valuations. Furthermore, rising
interest rates mean that the present value of expected future
corporate earnings (now revised downward) is also lower,
exacerbating the decline in stock prices.
|
|
|
S&P 500 |
-4.88% |
-23.87% |
Russell 1000 Growth |
-3.60% |
-30.66% |
Russell 1000 Value |
-5.62% |
-17.75% |
Russell 2000 Value |
-4.61% |
-21.12% |
Dow Jones US Real Estate |
-10.44% |
-29.37% |
MSCI EAFE (net) |
-9.36% |
-27.09% |
MSCI Emerging Markets (net) |
-11.57% |
-27.16% |
Bloomberg U.S. Aggregate Bond |
-4.75% |
-14.61% |
Bloomberg Municipal Bond |
-3.46% |
-12.13% |
Bloomberg U.S. High Yield |
-0.65% |
-14.74% |
Source: Morningstar |
As measured by equity returns through the third quarter, US
and global stocks are in a bear market, with declines of more
than 20% from their recent highs. For the first nine months
of the year, the S&P 500 declined nearly 24%. Most of those
declines came from the growth side of the market (down
more than 30%, as measured by the Russell 1000 Growth and
NASDAQ indices), where technology companies, especially,
retreated sharply. Having led the gains in stocks for much
of the past ten years, they have been leading the way lower
for most of the past twelve months. Value companies have
performed much better year-to-date – but are still down
roughly 17% for the Russell 1000 Value index and the much-watched
Dow Jones Industrials. Nevertheless, during the
third quarter, value stocks performed slightly worse than
growth companies, as fears of recession spread.
While bonds are often the beneficiaries of falling stock
prices and a “flight to quality,” that is not the case in this
market cycle, as the inflation-driven surge in interest rates
means the value of bond portfolios decline. In fact, the most
common measure of US bond market performance declined
year-to-date by nearly 15% -- only slightly better than the
performance of value stocks and the Dow.
Looking forward, investor expectations for inflation and the
trajectory of interest rates will likely remain the key drivers
of market conditions, though other factors can provide
unexpected positive or negative surprises for the market.
The midterm elections are looming, an event that often
creates market uncertainty. Many pundits anticipate a shift
in control of one or both houses of Congress. While that
could result in gridlock, the markets often respond favorably
to divided government that makes dramatic change (and,
therefore, uncertainty) less likely. The war in Ukraine, a
source of increasing worry in recent weeks, could move
things in either direction. Clearly, an early end to that conflict
would be welcome for many reasons, and especially to bring
relief to the untold human suffering that is occurring.
Uncertainties abound. Excluding the depression-era, the
average bear market for the S&P 500 has averaged about
16 months, so we may yet have more financial pain to deal
with. Even so, stock valuations generally have become
much more appealing. Some sectors of the market look very
attractive, providing opportunities for income as well future
growth. While recovery from losses in the bond market will
likely take time, recovery from stocks can come swiftly.
And the rising consumer prices that are currently battering
stocks and bonds will eventually flow through to corporate
revenues and the bottom line, meaning stocks may offer the
best long-term protection from our current bout of inflation.
That doesn’t mean we should all start buying stocks. That
decision should be considered in the context of your
personalized financial plan. Though uncertainties abound,
your CNB advisors are here to help you navigate our current
financial challenges.
Data as of 9/30/2022.
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