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.
In fact in my January letter I wrote the following:
Are we due for a market pullback?
Is it possible that rising rates and a richly valued market could cause a pullback in 2022? The second year of a presidential administration is typically the weakest year of a presidential cycle for the S & P 500 (LPL Research).
The combination of these two factors causes our team to suggest to investors we could be in for a more volatile market compared to the past 18 months. Additionally, the first few months in the second year of a Presidential cycle are generally more volatile and uncertain, but the trend has been for recovery in the latter part of the year when there is more political certainty.
Notably, our “growing dividend” portfolio and “current equity income” portfolio should be positioned well for this type of environment.
All of this has played out so far generally as expected yet the second half of the year has obviously not arrived yet. So we are not surprised by the type of year we have seen so far, market downturns are never fun, but inevitable as part of the long term investing journey.
The Rate Cycle Looks Normal So Far
Based on commentary from most Fed officials during April, an aggressive approach is most likely what we will see this year. As of this writing the Fed today raised the Fed funds rate by .5% as expected. One closely followed measure from the CME Group suggests a .50% increase in mid-June and another .50% increase in July.
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.
Performance bears this out. With four months behind us, the S&P 500 Index is off to its worst start since 1939 (LPL Research) and also one of the worst starts to the year for bonds.
And fears are rising that the Fed’s new-found inflation-fighting backbone might choke off economic growth. Should we be concerned?
GDP unexpectedly contracted in Q1 at an annualized pace of 1.4%, according to the U.S. BEA. But the decline was related to one-off factors.
A Few Positive Data Points
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 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.
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 are very careful to attempt to call market bottoms or tops, and it is not any easier for a TV analyst to make a correct call as well since no one has a crystal ball.
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.
We do not believe investors should be taking outsized risks. Successful investors are disciplined. They refuse to let excessive optimism or pessimism guide their decisions. We would continue to advocate, as we did in January, that portfolios focused on high quality dividend growth and high dividend companies continue to be positioned well to ride through this period of heightened volatility.
It is time to employ a disciplined approach and maintain recommended asset allocations. Most all of our clients have an Investment Policy Statement in place to prevent emotion-based decisions that can sidetrack you from your long-term goals. We strongly advise we update these with each of you and ask you either call or set a meeting to discuss.
If markets continue to slip shorter-term, rebalancing helps add to your positions when stocks are down, i.e., buying low.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss.
Investing involves risk including loss of principal.