John Gorlow
| Jun 13, 2022
It’s been a while, but bears are on the prowl again, showing up with increasing frequency in financial news. Through mid-May, the S&P 500 index was down for seven consecutive weeks, the longest losing streak since the dot-com bubble burst two decades ago. Stocks briefly descended into dreaded bear market territory, but strong gains in the week ending 27-May created some breathing room. The S&P 500 Index finished May with relatively flat returns. Still, anxiety was palpable as investors awaited the next inflation report.
The inflation news was grimmer than expected, with the 10-June report showing consumer prices shooting up at an annualized rate of 8.6% in May compared to a year earlier. The news surpassed economists’ forecasts and dashed hopes that inflation would decline rapidly over the summer as supply-chain bottlenecks eased and borrowing costs rose. The report torpedoed stock and bond markets, erasing recent gains and igniting fears that the Fed would have to take drastic action to crack down on inflation.
How bad was the sell-off? The S&P 500 dropped 2.9% after the 10-June report to lock in its ninth losing week in the last ten, bringing year-to-date returns on the index to negative 18%.
Value stocks have so far provided investors some shelter from the storm. The S&P 500 Value Index has fallen by about 9% year-to-date—a far better performance than the 26.4% drop in the S&P 500 Growth Index. Value’s strengthening relative performance began showing up about a year ago, and its continuing rise in 2022 has reinforced the belief that we are witnessing a durable shift in market conditions. This follows the worst decade in history for value stocks.
The inflation report sent bond prices tumbling and treasury yields rising to their highest levels in years. The day after the report was released, the two-year treasury yield zoomed from 2.83% to 3.05%. The 10-year yield also rose, but less dramatically, finishing the day at 3.15% up from 3.04%. The narrowing gap between the two- and ten-year yields signals that investors are more concerned about risks to economic growth (i.e., the next recession) than aggressive short-term Fed actions.
Underscoring worries about inflation, crude prices jumped after European Union Leaders said they would impose an oil embargo on Russia over its invasion of Ukraine. Front-end futures for Brent crude, the global benchmark, rose to $122.84 a barrel, their highest settlement since March.
Awaiting the Fed’s Next Move
Federal Reserve officials agreed at their meeting in May that the Central Bank must move faster than previously indicated to bring down inflation. Minutes of that meeting showed that most participants expected as many as three rate increases of one-half percentage point each in the months ahead.
Fed-fund future markets had already priced in anticipated quarter-point rises in Federal Open-Market Committee (FOMC) meetings in November and December 2022, plus two additional quarter-point boosts in early 2023, bringing the Fed’s key policy rate target to a peak of 3.5% to 3.75%. This contrasts sharply with the last published projections published by the FOMC in March. The fed’s policy rate is now 0.75% to 1%. Some economists project the Fed funds target to hit 3.75% to 4% next year, a quarter-point higher than market consensus (Barron’s, 13-June, Randall W. Forsyth).
Few will be surprised by more aggressive action from the Fed in its meeting this week. Some believe that we could see a three-quarter percentage point hike in the fed funds target, a demonstration of the resolve needed to rein in inflation as fast as possible.
How might the Fed’s actions affect stocks? The S&P 500’s P/E has corrected about 5 points, to about 16 times projected earnings, from over 21 last year. But that’s based on aggregate earnings estimates that have barely budged, despite a squeeze on profit margins from rising costs and slowing sales, in some cases. According to Refinitiv, S&P 500 earnings are expected to rise 11.3% in the 12 months from the first quarter of 2022. If interest rate expectations are still too low and earnings forecasts too high, don’t be surprised if stocks fall further (Barron’s, 13-June, Randall W. Forsyth). And if the Fed’s actions are more aggressive than experts predict, we may see more volatility before prices bottom out.
If there’s any consolation, “…it lies in the fact that financial markets have already done a lot of the Fed’s heavy lifting for it. Since the start of the year, bond yields have risen sharply; mortgage rates have surged; spreads on corporate bonds have widened; the dollar has climbed; and share prices have slumped. In a counter-factual world in which financial markets had shrugged off the Fed’s two interest rate increases so far, the risk of a hard landing for the economy would, paradoxically, be greater. Inflation pressures would keep building. But as things stand, interest rates may not have to be lifted quite as high as they otherwise might have.” (The Economist, 26-May, Prophets and Profits).
That’s an odd sort of “lemonade from lemons” scenario, in which stock and bond bear markets may be seen as positive developments, effectively performing the unpleasant task of tightening policies typically left to the Federal Reserve.
What to Do Now
For investors with the appetite, Commodities is one of the few mainstream asset classes that hasn’t been battered. Commodities have been unloved for years, mainly because returns have been poor, but also because the category is inherently volatile. The index tracking Vanguard Commodity Fund Strategy (VCMDX) has provided some relief against rising inflation.
But that may be small comfort when weighed against the extreme uncertainty of our present time. War, humanitarian crises, economic hardship, global warming … it’s only natural to wonder what effect these serious global issues will have on long-term investment performance. It is understandable to feel anxiety and deep concern, but don’t let panic or distress guide your investment decisions.
As Dimensional CEO David Booth reminds us, the role of markets is to price in uncertainty. Uncertainty never goes away. If it did, investing in stocks wouldn’t pay a premium versus relatively riskless assets. Reaping the benefits of the stock market requires a long-term perspective. Sometimes it also requires nerves of steel.
Investing in a broad market portfolio means you’re betting on human ingenuity and markets to solve problems. You’re not trying to figure out which stocks will thrive and which won’t recover. You’re not trying to answer “when” or “what next.”
Like most people, your memory of downturns will be dominated by the financial pain of 2007-2009 and the pandemic-induced collapse of 2020. Both events were severe and highly unusual big blows to the economy. But people, companies and markets adapt. In 2008, few would have forecast a nearly 11% annualized return from investing in the US stock market between 2008 and 2021. A dollar invested at the beginning of the period would be worth about $4.36 at the end of the period, but only for those who stayed the course.
If you have questions or concerns about your asset allocation, or if your life circumstances have changed in ways that require a portfolio review, please contact me. I am here to help.
Regards
John Gorlow
President
Cardiff Park Advisors
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