The first half of 2022 proved to be a reminder to investors of the unpredictable nature of
investing. While markets weathered the COVID pandemic and its economic and humanitarian
damage with surprising resiliency, they seem less able to adapt to the current issues
around inflation. Investors certainly knew coming into the year that interest rates would
be on the rise in an effort to quell higher prices, but no one anticipated how aggressive
the Fed would become after sitting on its hands through 2021. In the Fed’s defense, China’s
zero-tolerance policy on COVID has caused continued supply chain issues, and Russia’s
invasion of Ukraine sent energy and other commodity prices skyrocketing, both giving
inflation an unexpected tailwind. Either way, markets, both equity and fixed income, have
not reacted kindly to the new stance and the Fed’s three increases totaling 1.5%. This puts
rates well ahead of what was the original year-end estimate, with more rate hikes to come.
So where do we go from here?
In its simplest definition, inflation occurs when too much money chases too few goods and
services. During the pandemic, government stimulus programs significantly increased
the money available to consumers, while economic shutdowns shuttered factories both
here and abroad. While the stimulus spending had the desired effect, and the global
economy survived, it also led to the first meaningful uptick in inflation that we’ve seen in
decades. The Fed, deeming inflation as transitory due to the underlying causes, left rates
unchanged. Afterall, stimulus payments had ended, and factories were reopening, which
would lead to lower consumer spending on one side and increased output of goods on
the other. So, what changed? For one, China’s government has remained committed to its
zero-tolerance COVID policy, which has continued to include large-scale shutdowns and
quarantines. This has complicated and prolonged supply chain issues that might have
otherwise been resolved by now.
Second, the war in Ukraine. Few believed Russia would invade and incur the wrath of global sanctions, but on February 24th
they did just that. This has led to a substantial increase in oil, natural gas, and other commodity prices, all of which have
exacerbated inflationary pressures.
Finally, we’re confronted with a very tight labor market. While the unemployment rate has dropped to 3.6%, we still have
roughly 11 million unfilled jobs. This is good for workers but puts businesses in the position of having to significantly
increase wages to both attract and retain employees. If wage growth continues, it will put upward pressure on prices of
goods and services as companies try to maintain margins.
This leaves the Fed in the uncomfortable position of having to raise rates both faster and higher than anticipated. While
higher rates won’t alleviate supply chain issues, they will likely moderate demand for goods as the costs of borrowing
increase, thereby bringing the supply/demand dynamic back into alignment, as has happened in the past. The balancing act
comes as they attempt to slow demand, but not so much as to create a recession. If inflation does begin to ease through the
summer, and there are some recent indications it may, then the Fed may hold off on increases until later in the year. For now, however, the Fed will likely continue to publicly maintain its
tough stance as the negative sentiment it creates may be
useful in cutting demand on its own.
For investors it’s been an especially trying start to the year.
While most equity investors understand that volatility is
part of the game, and in the end the reason why they’re
compensated with higher returns over long time periods,
bond holders are not generally used to such swings. With
both asset classes down so dramatically at the same time, it
creates very unnerving times. As of June 30th, the S&P 500
Index was down -19.96%, and the Bloomberg Aggregate U.S.
Bond Index was down -10.35%. While some areas like value,
dividend payers and short-term bonds were down less than
others, there were few if any positive asset classes outside
of commodities and cash.
The threat of additional rate increases and the potential
for a recession will likely keep volatility elevated, but there
are positives. From a valuation standpoint, both bonds and
stocks look much more attractive than they did coming
into the year. Bonds, which yielded very little, now offer
reasonable income for conservative investors. Similarly,
equity valuations* have gone from very high at over 21x
forward earnings to now 15.9x, which is below their 25-year
average. This can be an indicator of better returns moving
forward, as well as to serve as a possible entry point for
investors looking to deploy cash.
Data from Morningstar
It’s also important to note that markets are forward looking,
and today’s prices have built in expectations for future
events. While rates will likely continue to rise, much of it
may already be factored into bond prices. And while a
recession may take place between now and the end of 2023,
equities have already entered bear market territory. As it
is, first quarter GDP was negative, and forecasts for second
quarter continue to fall, prompting some economists to note
that we may already be in a recession. Whatever the timing
may be, a recession is likely to be relatively mild given we
have not built up some of the excesses typically seen prior
to an economic downturn. Additionally, consumer demand
remains strong and unemployment remains exceptionally
low at only 3.6%, both of which support continued economic
growth.
*(based on S&P 500 Index, as of June 30th. Source Standard & Poor’s)
It’s disconcerting to see investment values drop, especially
when it encompasses all asset classes and styles; equity and
bond, U.S. and international, growth and value, small and
large. But in the end investors are rewarded for patience
through short-term downturns. In times like these the key
to focus on is not the return of a particular investment, but
rather your overall financial plan, and whether it meets its
goals over longer periods. Emotional, knee-jerk reactions
to temporary economic distresses are counterproductive.
That’s why your advisor can help you by making fact-based decisions to meet longer-term objectives by helping
you review your financial plan to ensure you are on track or provide insights on how to better manage during this
volatility.
Data as of 06/30/2022.
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