The convergence of high inflation, higher interest rates, a slowing economy, and the prospect of a recession have anxious investors on edge, as reflected in the stock market’s extreme volatility. Amid the constant stream of negative headlines, there is at least one morsel of good news: investor sentiment is declining—an indication that much of the bad news is already baked into the market.
The recent 75 basis point hike by a hawkish Fed—the fourth this year—was expected as it remains determined to get control of inflation. However, the market was hoping for an indication of a “Fed pivot,” signaling a reversal of its aggressive tightening policy and raising hopes for a softer landing. Fed Chair Jerome Powell gave no such indication at the November meeting, but he did telegraph the likelihood of smaller rate hikes in the future. As long as payrolls and wages—two indicators of concern to the Fed—remain overheated, there’s less chance of a pivot to a less hawkish stance this year, increasing the likelihood of a recession in 2023.
How Severe of a Recession Should We Expect?
Barring continued aggressive rate hikes by the Fed, we fall on the side of a softer landing for the U.S. economy with a worst case of a mild recession. As energy prices continue to ease, inflation should moderate in the months ahead, allowing the Fed to take its foot off the rate hike accelerator as it reaches its target rate of between 4.0% and 4.5% in 2022. Cooling inflation will also boost spending power which will bolster household and corporate finances and balance sheets while limiting the severity of a recession.
The economy should also get some help from normalizing supply chains, bringing more relief to commodity prices which have been trending lower in recent months. This should also reduce pricing pressure on durable goods, which have been the major cause of surging core inflation. The shifting demand from goods to services should also increase disinflationary pressure on durable goods, bringing core inflation under control.
Working against a soft landing is the overheated labor market. With twice as many job openings as unemployed, wage inflation is a sticking point for the Fed. The good news is consumers are benefiting from a tight labor market which is driving the consumption fuel they need to spend money.
Bull vs. Bear
Persistent fear over continued economic and market deterioration is driving stock market volatility. We’ve seen a couple of significant rally attempts in the last several months—a record one-month surge of 9.1% in July, followed by another record month in October of 14%. But those two months bookended one of the steepest market declines in the last three years between mid-August and early October.
It seems this bear market is conflicted. It has been fighting the tide of strong corporate fundamentals, a sign that the underlying economy is strong, while it is being fueled by the prospect of higher interest rates.
Corporate profits have shown strength throughout the year, reaching a 70-year high with a 15.5% second-quarter increase. Though the S&P 500 net profit margin decreased to 12% in the third quarter, it is still above the 5-year net profit margin of 11.3%. That marks the 7th consecutive quarter that the net profit margin has been 12% or higher. The only other time the net profit margin has hit 12% or higher in the last decade was the third quarter of 2018.
The equity markets seem to be more consumed by uncertainty over possible Fed actions in its war against inflation, fearing that it could act too aggressively. Investors have been hoping for a Fed pivot since July, which has yet to materialize, resulting in increased market volatility.
Keeping Market Volatility in Perspective
Even though bear markets tend to be short-lived relative to the length of a typical market cycle, many investors, acting out of fear, make short-term decisions that can adversely affect their long-term investment performance.
While we can’t know how long this bear market will persist, we do know that it will end eventually and give way to another bull market. Historically, bear market cycles last an average of nine months and occur about once every five and a half years. Since 1929, the stock market has generated positive annual returns 75 times, interrupted by brief bear markets 20 times.
More significantly, history shows that the stock market tends to increase at a faster rate following a bear market, advancing an average of 33% following a market decline of 20% or more. That’s nearly double the two-year median increase, which has enabled investors to fully recover their losses and then some within two years.
The critical lesson for investors is that bear markets have always been little more than temporary interruptions of a more enduring long-term advance. While some bear markets can be worse than others, the stock market has always rewarded investors who exercise the patience and discipline to stick with a well-conceived long-term strategy.
While we are cautiously optimistic that the underlying strength of the economy will cushion a downturn, we are keenly aware that other factors, such as the Fed’s actions, can impact its momentum. However, we are also confident that investor concerns over a worst-case scenario have already been priced into the market.
Our strategy continues to focus on company-specific performance in determining the proper level of diversification and overall equity exposure for our ETF strategies. We urge all our investors to exercise patience and discipline during extreme market volatility, for this too will pass.