Our Perspective and Strategy During Turbulent Times
It’s been a difficult year, to say the least. As September comes to a close, we’ve weathered a disappointing month in the financial markets after a relatively benign August and a strong July. As is the case in any bear market, investors are braced for more to come. Our in-depth quarterly commentary will be shared soon, so in this post we provide a shorter summary on the forces that brought us here, how we’re responding, and what to expect going forward. Most importantly we know that in the long run, bear markets are normal. What happens over 12 or 18 months has surprisingly little impact on the long-term outcome for investors and their ability to achieve their goals. In fact, our investment approach is designed to selectively take advantage of market excesses in order to increase long-term returns – even if those actions can be uncomfortable while a downturn is happening.
Inflation has been the catalyst for this difficult year
Prior to this year, a sharp spike in inflation was initially driven by transitory factors like COVID-driven supply chain disruptions and then in early 2022 it was exacerbated by the war in Ukraine. The Fed’s response to rising inflation has been to aggressively raise interest rates – their only means of bludgeoning economic activity to reduce aggregate demand and in turn bring inflation in line with their longer-term targets. The result has been steep declines in both stocks and bonds.
While headline CPI inflation (excluding food and energy) seems to have peaked, core inflation measures have continued to rise and are far above the Fed’s 2% target. This indicates inflationary pressures have become more widespread throughout the economy, rather than driven by a few extreme outliers as in 2021.
Some of this broad-based core inflation is still due to the initial “transitory” COVID-related supply-side disruptions and production/distribution bottlenecks, which central banks can’t do anything about. But the good news is that many of these supply-chain disruptions are dissipating as the pandemic recedes globally. However, the demand-side drivers of core inflation in the U.S. have not yet peaked, let alone demonstrated the consistent month-over-month declines that Fed Chair Jerome Powell says the Fed is looking for as “clear evidence” inflation is headed to their 2% target. As such, and as expected, the Fed has continued its path of aggressive rate increases and has signaled there is more to come.
The Fed’s policy hammer of higher interest rates will eventually pound down GDP growth and increase unemployment. The odds the Fed can engineer an economic soft landing – where the U.S. economy slows sufficiently to tame inflation but does not fall into a deep recession with much higher unemployment – are increasingly slim.
The economic growth outlook has gotten dimmer, driving stocks lower
Along with persistent core inflation, the shorter-term growth outlook has worsened for the U.S. and most of the globe. Historically reliable economic indicators including the Leading Economic Index and an inverted yield curve point strongly toward a recession, and that is now our base case scenario for the next 12 months.
The stock market is in effect a collective opinion of what all this economic news will mean to corporate profits, and that opinion is expressed in stock prices. Through the first half of the year, we saw sizable declines in stocks, followed by a rally over the summer. But as we wrote in earlier commentaries, we expect declining corporate earnings to follow, and as that is becoming more apparent the markets have turned sharply south once again.
We are making small adjustments to our target portfolio allocations
Our focus is on longer term fundamentals and valuations, and we are not in the business of making shorter term bets on the markets. However, our analysis tells us that at current valuation levels, stocks may not be adequately discounting the potential for further earnings declines, and that has led us to revising some of our underlying assumptions and reduce the nearer-term return (next five years) we expect from stocks.
At the same time, the sharp increase in interest rates this year has driven bond yields up to more attractive levels – more attractive than they have been in about a decade. On a relative basis, core investment-grade bonds now look much better versus stocks than at the start of the year. Further, core bonds provide good downside protection, which would be especially helpful if conditions turn out to be worse than currently anticipated. For these reasons, we are making a modest shift to our target allocations to increase core bonds and reduce equities. It is also possible that we may see further declines in stocks that could make their prices highly attractive for the long-term, and as always, we will be looking at adding to equities at that time.
It is also important to note that even during a very difficult environment for both stocks and bonds, there have still been a few bright spots – such as some areas of fixed income, trend-following managed futures, direct real estate, and private equity. These areas have served to provide diversification to portfolios that helped buffer them a bit during the broader market downturn.
The short term can be unnerving, but our strategies are for the long term
After more than a decade of generally strong positive performance from both stocks and bonds, the recent environment provides an important if unwelcome reminder of the value of diversification: it helps you weather downturns rather than selling at the wrong times (which is usually at or close to a bottom), and in turn helps achieve long-term financial goals.
We understand intellectually and emotionally that markets like this are disconcerting and can lead one to question their long-term strategy. We are here to partner with you to manage through these market declines, which we know are part of investing. As disciplined investors, we will find intelligent ways to stay the course within your overall investment strategy and prepare for the long run without allowing shorter term market volatility to distract us.
We welcome questions about your individual situation or the markets in general, so please don’t hesitate to reach out to your advisor. As always, we appreciate your trust and confidence.