Apparently, what the Federal Reserve giveth, it taketh away. After almost 15 years of policies intended to maintain low interest rates and stimulate the economy, the Fed has dramatically raised rates this year to increase borrowing costs and slow spending in an attempt to lower inflation. The consequence is likely to be slower economic growth, but there is also a risk of triggering a recession. Whether inflation can be tamed without causing a recession is yet to be determined.
The Fed embarked on what became over a decade of accommodative policy in response to the financial crisis that began in 2007, at the start of the Great Recession. In addition to providing immediate liquidity to banks to save the financial system from collapse, the Federal Reserve lowered its benchmark interest rate, the federal funds rate, essentially to zero in order to stimulate the economy. When these actions did not provide enough economic stimulus, and with the federal funds rate already at zero, it implemented programs to purchase assets from investors, a practice called quantitative easing. As the economy gradually recovered over the next ten years, the Fed attempted to reverse these extraordinary and unprecedented actions, hoping to slowly raise interest rates to normal levels and reduce the size of its balance sheet. However, in 2020, when the global pandemic forced the shutdown of all major economies, the Fed and global central banks once again felt compelled to act to support their economies. Interest rates, which had just started to rise at the end of 2015, were effectively pushed back to zero. In the U.S., the 10-year Treasury Note yielded less than 1.0%. The policy worked well to reassure investors, and together with vast fiscal stimulus from Congress, eventually led to a strong recovery and economic growth. It also had unintended consequences. Most major economies have since experienced their highest rates of inflation in more than 40 years. Labor shortages, supply chain bottlenecks, and the war in Ukraine have further added to inflationary pressures. After years of pedal to the metal, the Fed abruptly slammed on the monetary policy brakes. The federal funds target rate has risen from 0.00%-0.25% at the beginning of the year to 3.00%-3.25% today. Both equity and fixed income markets have suffered as a result.
The S&P 500 Index lost 4.9% in the third quarter, with losses picking up significantly in September as investors worried that higher interest rates would trigger a recession. All major stock indices experienced losses greater than 20% for the year-to-date period as shown in the table below.
The table below shows the performance of major equity indices for selected time periods.
Equity Performance for Periods Ending on September 30, 2022
|Total Return Index||Market Sector||Quarter||YTD||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||-4.9%||-23.9%||-15.5%||8.2%||9.2%||11.7%|
|Russell 2000||Small U.S. Companies||-2.2%||-25.1%||-23.5%||4.3%||3.6%||8.6%|
|MSCI EAFE||Developed Int’l Markets||-9.4%||-27.1%||-25.1%||-1.8%||-0.8%||3.7%|
|MSCI EM||Emerging Int’l Markets||-11.6%||-27.2%||-28.1%||-2.1%||-1.8%||1.1%|
In the third quarter, stocks rallied through mid-August. With second quarter earnings stronger than expected and signs that inflation might be peaking, investors seemed to believe that a recession could be avoided. But on August 26, Federal Reserve Chair Jerome Powell delivered a speech at the Jackson Hole Economic Symposium that left significant concern in the minds of investors. He stated that the Fed would continue increasing rates to a level that will bring inflation down to its 2% target, that it would maintain a restrictive policy stance for some time, and that the economy was likely to experience a “sustained period of below-trend growth.” The Federal Reserve has a dual mandate, low and stable inflation and maximum employment. With inflation near historic highs and unemployment near historic lows, the Fed has indicated it is willing to put an end to its overly accommodative policies and make the difficult decision to slow economic growth, even if unemployment rises and asset prices pull back. The Fed has signaled that it will raise its target rate to 4.0% by year end and to 4.5% in 2023, if necessary to address inflation. The Fed’s “hawkish” inflation stance substantially raises the probability of a recession.
In light of the Fed’s current position, it is likely that economic indicators will show weakening conditions over the near term. However, it is difficult to say how this news will be interpreted by the markets. Lower consumer confidence, rising unemployment, and weaker durable goods orders, while generally viewed negatively, could be signs that inflation will materially ease. This could in turn cause the Fed to be more patient, potentially forgoing further rate increases or hiking in smaller increments. It is possible that the market will view weak economic news as favorable as long as it doesn’t foreshadow a severe recession.
Given the decline in stock prices and the likelihood that interest rates will continue to rise, it is no surprise that the majority of investors are currently pessimistic. The American Association of Individual Investors (AAII) recently reported that 60% of respondents to its weekly market survey are bearish. That has occurred only five previous times since the survey started in July 1987. According to Bespoke Investment Group, the S&P 500 Index generated average returns of 33.2% in the year following a bearish reading greater than 60%. Incidentally, when less than 10% of investors were bearish (i.e., when most were bullish), the market produced an average loss of 16.1%. While there is no guarantee that history will repeat itself, the past occurrences demonstrate how investors are often wrong and tend to overreact to market conditions.
The most positive aspect of the current market is that equity valuations have become more attractive, primarily because stock prices are lower. According to FactSet Research, the forward price/earnings (P/E) ratio for the S&P 500 is currently 15.4, compared to its 5-year average of 18.6 and 10-year average of 17.1. While earnings estimates have been ratcheted down in recent weeks, analysts are projecting 7.4% earnings growth for 2022 and 7.9% for 2023. FactSet also notes that analysts are forecasting an average stock price increase of 29.4% over the next year for companies comprising the S&P 500. Morningstar’s analysts currently estimate that companies within their research coverage are currently trading 21% below their fair value. In past periods, this level of valuation proved to be a good indicator of above-average future performance.
The bear market has removed a considerable amount of speculative activity from the overall market, which we also view as positive. Notable pandemic plays such as Roku, Zoom, Peloton, and DocuSign have all declined more than 80% from their highs. Crypto currency has also crashed with Bitcoin currently trading more than 70% below its all-time high.
In equity bear markets, fixed income securities usually provide positive returns. This occurs as investors shift from riskier investments like equites to lower-risk fixed income securities. However, the current economic environment is different from most. The Federal Reserve’s actions are overwhelming market forces that would normally generate positive fixed income returns when investors expect a weakening economy. As a result, the Bloomberg Aggregate Bond Index is experiencing its worst year since its inception in 1980. Several major bond indices are shown in the following table.
Fixed Income Performance for Periods Ending on September 30, 2022
|Total Return Index||Market Sector||Quarter||YTD||1-year||3-year||5-year||10-year|
|Bloomberg U.S. Aggregate||U.S. Taxable Bonds||-4.8%||-14.6%||-14.6%||-3.3%||-0.3%||0.9%|
|Bloomberg U.S. Municipal||Tax-Free Bonds||-3.5%||-12.1%||-11.5%||-1.9%||0.6%||1.8%|
|Bloomberg Treasury 1-3 Year||Short-term Treasuries||-1.5%||-4.5%||-5.1%||-0.5%||0.5%||0.6%|
The Bloomberg U.S. Aggregate Index is the broadest representation of the taxable U.S. bond market. As can be seen in the table, the year-to-date performance has negated almost all the positive returns of the previous ten years. While the recent historical performance has been decimated, the higher interest rate environment makes fixed income investments more attractive when looking forward. For example, the yield on the 2-year Treasury Note has increased from 0.73% at the beginning of 2022 to 4.21% currently.
Without a doubt, bear markets are difficult periods for most investors. No one is comfortable seeing a decline in the value of their investments. While human emotion will drive many investors to sell when prices are low in the hope of cutting their losses, this strategy will usually result in poor long-term performance, since markets have historically recovered from all previous bear markets. Although it is not possible to predict if the stock market will fall further in the short-term, we are still confident that equities will likely produce attractive returns for disciplined long-term investors. We also believe once interest rates stabilize, fixed income securities could play a more positive role in the total return of investment portfolios again. Our economy and markets have survived many challenges in the past. Investors who have been able to tolerate adverse conditions have been rewarded. We do not see anything that leads us to believe it will be any different this time.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.