May 2022 Market Update

Since the beginning of the year, the markets have been rattled by persistently high inflation and the question of how the Federal Reserve might respond (not to mention the war in Ukraine and lockdowns in China all leading to continued supply chain issues).

In March, it began with a simple 25 bp (bp = basis points, 1 bp = 0.01%) rate hike in the fed funds rate to 0.25%-0.50%.

Unlike the rate-hike cycle of the 2000s and the very gradual increases in the 2010s, inflation is a big problem today.

We are receiving comments from key Fed officials that “it is of paramount (my emphasis) importance to get inflation down" (Wall Street Journal).  So we can’t expect the baby steps we’ve grown accustomed to.

This is your father’s rate-hike cycle

We saw the Fed raise the Fed Funds rate by 50 bps last week, which was widely expected.  Markets had one big up day that day as there was relief related to comments of not expecting 75 bp increases, but that was short-lived as apparently the reality set in that multiple 50 bp increases were still likely.

That is to say, we may see the most aggressive pace of tightening in almost 30 years.

An aggressive tightening cycle can generate volatility in two ways.

First, higher interest rates compete more effectively for an investor’s dollar, siphoning cash away from stocks. Second, higher interest rates can slow economic growth, which may put the brakes on profit growth.

In addition to higher interest rates, the Fed is set to let the bonds it purchased in 2020 and 2021 run off its balance sheet in a measured fashion. In other words, investors are not only grappling with higher interest rates, but the runoff in bonds may create additional obstacles.

Performance bears this out. With four months behind us, the S&P 500 Index is off to its worst year-to-date start since 1939, according to Dow Jones Market Data (WSJ).

And fears are rising that the Fed’s new-found inflation-fighting backbone might choke off economic growth.  The biggest concerns discussed around this are discussions of recession and stagflation.  Where do things stand now compared to history when it comes to recession?

While inflation is raging and other components have changed from positive to neutral there still are important parts of those indicators that have held up well, especially consumer spending, housing, and employment data.

GDP unexpectedly contracted in Q1 at an annualized pace of 1.4%, according to the U.S. BEA. But a big part of the decline was related to one-off factors.

During Q4 2021, GDP surged 6.9%—also due to technical factors. We believe it’s better to average the last two quarters. Besides, an acceleration in consumer and business spending during Q1 was encouraging.

Here are a few other encouraging stats.

An astonishing 1.7 million jobs were created in the first three months of the year, per the U.S. BLS.

First-time claims for unemployment insurance are hovering near the record low set in the late 1960s—records date back to 1967 (Department of Labor). Further, business openings are at a record high (U.S. BLS), in part because business activity has been strong.

We historically wouldn’t be seeing these numbers if the economy were contracting.

Let’s look at some of the anecdotal evidence. If the economy is weak, consumers shy away from discretionary purchases. When it comes to travel and entertainment, that’s not happening.

Airlines are seeing strong demand (CNBC), and an April 23 story in the Wall Street Journal highlighted aggressive pricing for summer concerts as fans eagerly line up to buy tickets.

Here’s an interesting remark from the CEO of McDonald’s, who said the consumer is in “good shape” because customers are still ordering items for delivery, the most expensive way to buy due to the hefty convenience fees (CNBC).

Put another way, we complain about inflation, but we complain while in line to make a purchase.

Still, stimulus money stashed in savings accounts may be aiding overall spending, which may be artificially supporting growth. Per U.S. BEA data, incomes are not keeping up with inflation, which could eventually create resistance to higher prices just as the Fed is lifting rates and raising the cost of money.

What will it take to stabilize the market?

High inflation, worries about the Fed, slowing global growth, and the ongoing war in Ukraine are well known. The pullback in stocks reflects the high level of negative sentiment, and at least in part, stiff headwinds are already priced in.

Are we at or near a bottom? We don’t try to call bottoms or tops, and that articulate analyst on the financial news network may be smart, but they don't have a crystal ball either.

Let's share some thoughts about various possibilities.  

If Russia were to suddenly end its hostilities in Ukraine, a significant short-term headwind would be eliminated. Sadly, this best-case scenario, which would end the needless suffering in Ukraine, is highly unlikely.

More realistically, investors want signs that inflation is not only peaking but on a downward path. Why? It would reduce the need for steep rate hikes.

Powell and the Fed are hoping to slow inflation without tipping the economy into a recession. But they will need skill and some luck.

For starters, the dollar is flexing its muscle on foreign exchanges. A strong dollar may reduce import price inflation. But the Fed will need more help from the supply chain, which has been slow in coming. Today, new Covid lockdowns in China are exacerbating problems as well as food and fertilizer issues relating to Ukraine, Russia and Belarus.

We do not believe things are positioned for investors to be taking outsized risks to try to “time the bottom”. Successful investors are disciplined. They refuse to let excess optimism or pessimism guide their decisions. 

In times of significant volatility like this it can be appropriate to take additional risk off the table.  Fixed income returns from bonds have been nearly as bad as stocks and definitely have not provided the non-equity correlation factor typically associated with them due to the interest rate increases.  Portfolio risk mitigation is requiring more creative choices as well as allocations to cash (which aren’t coming anywhere close to keeping up with inflation, but has been one of the few safe havens).

It may be time to employ a disciplined approach that maintains asset allocations while identifying opportunities to adjust portfolios responsibly to a broader set of options than we’ve used at times in the past.  Commodities, metals, energy, utilities, consumer staples etc. are industries that you may have had limited exposure to in the past, but are the areas that have substantially outperformed the technology and consumer discretionary stocks that have dominated returns for years.

If markets continue to slip shorter-term, rebalancing helps add to your positions when stocks are down, i.e., buying low.  We have recently made some of these rebalances in our managed portfolios and are in higher cash positions than we have been across the board in our models.

If you have questions or would like to talk, we are only an email or phone call away.

Jeff Boyd

The market indexes discussed are unmanaged and generally considered representative of their respective markets. Individuals cannot directly invest in unmanaged indexes. Past performance does not guarantee future results. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. No investment strategy can guarantee a profit or protect against loss. This material is not intended to be construed as tax or legal advice. Always consult your tax and/or legal professional for details regarding your specific situation.

 Thanks to Horsesmouth and Main Management for some of the data provided.  The information and opinions presented are for general information only and are not intended to provide specific advice or recommendations for any individual. You should contact your investment representative, attorney, accountant or tax advisor with regard to your individual situation. The opinions of the presenter do not necessarily reflect those of Independent Financial Group, LLC, its affiliates, officers or directors.