Greetings! I trust that this finds you well and enjoying life.
With all of the activity in the economy at present I felt the following would be of interest and use. I resourced it from the investment advisory service we use at Armor to manage client money. I thought they did a good job at detailing where we are and why in a concise way.
We are in one of those era’s we go through from time to time that involve economic uncertainty and market volatility. I believe that an informed investor is a strong investor.
Therefore, if you have questions or concerns about your retirement plan or any aspect of finance, don’t hesitate to call. I look forward to speaking with you.
Jeff Christian CFP, CRPC
Labor Day indeed signifies the Wall Street ‘New Year’ for financial markets, with attention already turning from the current year for the most part, and toward Q4 and 2023. There are several headline items worth watching that may drive sentiment and potential volatility in coming months.
- Inflation. There has been progress, with a deceleration in the pace of increase in areas such as used cars, which had been a problem. Lower oil prices helps the headline number the most, and supply disruptions in global trade are slowly improving. Goods inflation is now morphing into higher services inflation, so we are not past the problem. Additionally, from a formal CPI standpoint, shelter inflation (from both higher rents and home prices, the latter of which have only recently begun to slow) is an expected upward force on prices. While the worst may be over, levels may remain above the 2% target for a few years potentially. Even if that’s the case, 3-4% on a year-over-year basis would be a welcome change compared to the more consumer-damaging 8-9%. It’s noteworthy that historical 12-month inflation has been far higher than the 2% Fed target—4.0% over the past 50 years, and 3.2% since the CPI’s creation in 1913.
- Federal Reserve. The probability of rate increases has picked up a bit, with expectations for a 0.50% move in Sept. now having evolved to 0.75%. The robust language and pace of the Fed have been notable in recent public comments. They’ve announced the specific focus being reducing inflation (through dampening economic demand, the only factor they can control), even if this causes consumer ‘pain’. Whether that remains true if the economy falls into recession remains to be seen, but for now, we can take this at face value.
- Interest rates. Short-term rates follow Federal Reserve policy, and these have unsurprisingly been rising steadily. However, long-term rate predictions aren’t quite as easy—these follow economic growth and inflation expectations, which have tended to regress to the mean. As such, recent treasury yields look less dramatic when considering an expected inflation drop towards normal levels (even if levels remain higher than target for up to a few years) and economic growth drifting back to trend levels around 2%-ish. A key question markets are trying to determine: what is the Fed’s terminal rate? In recent weeks, estimates have risen from around 3.50% to more like 4.00%. After rates reach that level, it’s possible the Fed stays put for a time, if policy is assumed to be tight enough as to not cause undue economic damage but also allow inflation to gradually ease to a natural rate. However, another pervasive view is that the Fed ‘breaks’ the economy through fast rate hikes, and will need to cut rates at some point in 2023. The good news for discouraged bond investors is that higher rates raise expected returns for bonds, which tend to track starting yields. (Just for example, 4.00% policy + 1.50% investment-grade corporate spread = 5.50% return, which is around the long-term average for bonds.)
- Economic growth/recession odds. Activity has been slipping, with two straight quarters of negative growth, although this hasn’t been defined as an official recession. However, indicators are mixed, with manufacturing and services sentiment remaining expansionary, and labor markets strong, although consumer debt is rising along with higher wages. Economists aren’t known for making outright recession calls outright, but the consensus is rising for the coming year, and close to a near certainty over the next two years. At best, growth isn’t expected to turn sharply positive in coming quarters. Of course, this matters as GDP growth translates into assumptions about corporate earnings.
- Earnings. Through Q2, earnings growth has come in at over 5%, a surprisingly persistent result considering the economic weakening. A risk for Q3 and Q4 is that, in keeping with traditional recessions, earnings could decline by -10% up to -30%. Lower earnings could subsequently pressure stock valuations and prices, so additional market volatility this fall (even testing prior lows) wouldn’t be a surprise. Market timing isn’t advised, though, as recessions haven’t been great times to abandon equities (results during recessions themselves have been mixed), but stock prices have tended to find a bottom and start recovering well before recessions end.
- European energy environment. This includes the announcement (partially a surprise, partially not) of the Russian Nord Stream pipeline closure. Several nations have ramped up, or are in the process of ramping up, LNG capabilities for winter, but there will be pressure on both residential and industrial usage. While it appears the probabilities of a European recession have moved sharply higher (and higher than chances in the U.S.) largely due to these effects, the depth and severity remain in question. Valuations in European equities already largely discount this negativity, with the MSCI Europe index P/E just above 10x—a level in line with recessions.
- China. Another round of selected pandemic lockdowns has pressured sentiment. As it stands, weaker growth has prompted fiscal stimulus. However, the government has been careful to not overdo it, particularly in segments such as real estate where a careful balance between not propping up asset bubbles, bailing out troubled developers, and satisfying disgruntled homebuyers is playing out.
- Covid. This wildcard isn’t done yet, especially with an ongoing threat of new lockdowns in China, although the situation has dramatically improved from that of two years ago. While the medical component has evolved into an endemic stage, impacts persist in supply chains, travel, and real estate, such as office and retail properties. Some of the still-lagging areas may improve steadily, while others could be more persistent—requiring market assumptions to adapt.
- Seasonality/Technicals. We hesitate to put too much emphasis on these factors, as they aren’t always consistent from one year to the next. The S&P had retraced upward about 50% of the first half’s -23% correction, but wasn’t able to break above the technically-significant 200-day moving average. (Prices trading above that mark are seen as bullish from a momentum standpoint, although it’s possible investors care about that timeline only because it seems others care about it.) Since 1925, September has been the worst-performing and most volatile month for equity markets (in fact, the only month with a net negative return). However, the 4th quarter of each calendar year has been the best-performing quarter, even if it contains bouts of volatility from time to time (October has been notorious for drama).
- US mid-term elections. These can be a source of volatility, but it has tended to be short-lived, with stronger later-year stock market recoveries common. The incumbent President’s party has often lost Congressional seats, although, as we’ve seen for decades, the party in charge isn’t really that important for stock returns (contrary to popular belief).
Happiness does not come from doing easy work but from the afterglow of satisfaction that comes from after the achievement of a difficult task that demanded our best.Theodore I Rubin