I was chatting with a colleague recently who relayed the following story: a mutual friend who is retired had to cancel plans for a social get together. It seems the friend’s husband was frantic about something Jim Cramer had said about the financial markets on CNBC and was demanding an immediate meeting with their broker to adjust their portfolio.
What power the media can have over us! It is hard to conceive that anyone would cancel plans or adjust their portfolio based on the rantings of Jim Cramer. If one is that anxious about their investments, there must not be a solid financial plan in place – or at least not one that the client trusts. Admittedly, this is an anxious time and we all have many questions, but financial journalists and commentators shouldn’t be relied upon for the answers or advice.
There are three dominant issues at play for the economy and financial markets, and they all circle around the theme of uncertainty. The first issue is the timing and pace of interest rate increases. The second issue is stock valuations and volatility. And the third dominant issue involves both inflation uncertainty and the possibility of recession. We have been discussing these topics for a while, but what is changing is the order of prioritization and the degree to which they are contributing to investor uncertainty and market volatility.
1. Timing and Pace of Interest Rate Increases
Regarding interest rates, trying to decipher the Fed is like trying to decode the Enigma machine. Last week, Federal Reserve Chair Jerome Powell said, “Inflation is much too high.” While nearly everyone agrees with that statement, the fear is that the Fed will raise rates so quickly and heavy handedly that the economy will tip into a serious recession. There is a story behind the story, though. Fed Chair Powell reiterated the concept of a Fed Funds “neutral rate” of 2-3% and also stated that a 0.75% rate hike was off the table. This was interpreted by many observers to mean that the Federal Funds Rate will go back to what it was in 2019, still well below the 5.25% rate in 2007 or the 6.5% rate in 2000. Yet Powell has been clear in his resolve to do “whatever is necessary” to curb inflation. Markets are clearly confused about what the Fed will do this year and whether the cure (rising rates) could be worse than the disease (inflation). Only time will tell.
Are we headed for a recession? Maybe. What the Federal Reserve is attempting to do to stave off inflation is kind of like tapping your car brakes on an icy road – it takes finesse. Supply chain problems and Russia’s invasion of Ukraine are contributing to inflation and are largely out of our control. There are many other issues that we could explore, and they are inter-related. Economies and investments work in a complex system, not silos. This week, stocks are reacting to news that major retailers reported higher costs and weakening sales, which could be a harbinger of a recession.
Our view at this time is that if a recession is triggered by Fed rate hikes, it would be relatively mild and worth the pain to stifle inflation, which is a much more serious long-term problem. An economy based on zero percent interest rates is neither healthy nor sustainable. In recent years, we’ve become accustomed to this world of low interest rates, but things were not always this way. In May of 1992, three decades ago, the 30-year mortgage rate was 8.6%. In only 13 of the last 30 years, just 40% of the time, have mortgage rates been below 5%.
While it’s troublesome to see loan rates going up, remember that rising rates also mean you will earn more income in savings accounts. Higher yields improve the reinvestment returns on bond portfolios, which is an underappreciated source of return for retired people.
2. Stock Valuations and Volatility
The second issue involves stock prices and how they will react to higher interest rates. Stock volatility has been quite high and seems to spike in response to comments from the Fed. There have been numerous trading days with dramatic price drops and gains. You might be wondering this: if markets are efficient at pricing assets, then why so much volatility? In addition to recession risk, volatility is also related to the uncertainty around future interest rates. The math of equity valuation models says that when the discount rate (i.e., interest rates) increases, valuations decrease. The problem is that as rates have begun to rise from ultra-low levels, those changes are causing a magnified impact on valuation models. This is especially true for highly leveraged stocks or high-flying growth stocks that have little support from earnings, cash flows or dividends. Hence, volatility.
3. Inflation Uncertainty and the Possibility of a Recession
The final issue we want to address is inflation. Not since the 1970s have we experienced inflation at this current level. And, never before has the Fed had such a large balance sheet to unwind – remnants of monetary stimulus from the great financial crisis and global pandemic. Threading the needle comes to mind and it is not surprising that investors are on edge. Hence, uncertainty.
So, here we are. The S&P 500 is down 6 weeks in a row, likely headed toward a seventh, the longest stretch of consecutive down weeks since 2011. The last time that the S&P was down 7 weeks straight was in 2001. When stock prices fall dramatically during a period of economic uncertainty, it’s easy to become alarmed. The media are not helpful – they get paid to sell advertising based on viewership and clicks. Per Bloomberg, there were more than 8,200 articles last week about “bear markets,” the 2nd-most of any week in the last 10 years. We all know the saying, “bad news sells.” Uncertainty feeds on itself.
During times like this, it helps to use a telescope rather than a microscope to get a perspective on investments. Yes, the S&P 500 index is down more than 17% YTD, possibly headed toward official “bear market” territory. Yet, at current levels, the index is up over 60% from May 2017. What we are seeing now is not out of the ordinary. Would it surprise you to know that in 14 of the last 42 years, the S&P 500 has had at least a -17% intra-year decline? Or that in 22 of the last 42 years, there has been at least a 10% decline from the high of the year to the low? Stock volatility and market inflection points are uncomfortable to experience but don’t necessarily cause long-term damage to a savvy investor. There is no better way to combat uncertainty than to be broadly diversified and to focus on key drivers of return such as cash flows, profitability, valuation, and size.
What are some of the positives? The U.S. economy, particularly the labor market, is robust and American households have healthy balance sheets. Higher interest rates mean that you will ultimately be able to earn more income from bonds and money market accounts. There are other positives (surprises) that may be in the cards: stable manufacturing and economic activity, lower energy and food prices, easing supply chains, slowing inflation, fewer rate increases than forecast, and a resolution to the Ukrainian crisis.
What Should An Investor Do?
In the face of negative world news, falling asset prices, and the risk of recession, what should a smart investor do? Why not go to cash to eliminate volatility? It’s tempting to bail out. But this would be a mistake for most investors, and we DO NOT recommend this path. Short-term volatility and market declines are not a problem for long-term investors with diversified portfolios. Whereas cash is always a long-term loser, under even modest inflation scenarios.
At Modera, we remain disciplined, long-term investors with a strategic focus. We emphasize quality, profitability, valuation and diversification across asset classes, geographies, size, and style. We rebalance to manage risks. When appropriate, we employ techniques such as tax loss harvesting to benefit our investors. Like well-trained airline pilots, we rely on our processes to bring everyone to safety.
As always, we thank you for the trust and confidence you place in us. We welcome your comments and questions. Please let us know how we can assist.
Karen R. Keatley, MBA, CFA®, CFP®, Principal & Chief Wealth Management Officer
George T. Padula, CFA®, CFP®, Principal & Chief Investment Officer
and Your Modera Wealth Management Team
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