The Federal Reserve subscribes to a “flexible” 2% average inflation target as its long-term goal for price stability. In order to manage their dual mandate of price stability and full employment, they expand or compress the money supply, traditionally through interest rate hikes or reductions. US interest rates have been declining for over forty years despite six tightening cycles since 1982. Each tightening cycle ended lower than the prior which ultimately led to interest rates approaching near zero in 2008 and for most of the past decade.
Investors and consumers alike benefit from low interest rates. Low rates support asset prices and stocks, bonds and real estate values have all appreciated as a result. The recovery following the Great Recession was long and stable, finally brought to a halt when COVID hit our shores. Unprecedented trillions of fiscal and monetary stimulus that followed may have prevented an economic disaster, but also sowed the seeds for high inflation.
For many months, the Fed dismissed high inflation as transitory. We wrote about their dual mandate in our third quarter market commentary last year and concluded:
“We do not expect the supply chain issues and labor shortages to suddenly disappear or inflation to return to the 2% Fed target any time soon. We are experiencing an unprecedented set of supply side disruptions, tight labor markets, trillions of government stimulus and easy monetary policy. We should not be surprised by the current conditions.”
Since then these supply side issues have only been amplified by war in Europe and China’s continued commitment to a “zero-COVID” policy. The Consumer Price Index increased 9% in June compared to the prior year.
Our views on inflation have not changed. The question remains if the Fed has the correct tools to balance the supply/demand equation. The Fed is not powerless, but central bankers haven’t had to deal with inflation of this magnitude in forty years. Solving the supply side is not within their control. Reigning in demand without triggering a recession will be exceedingly difficult. The Fed has to somehow maneuver a tough trade-off. Do you stabilize inflation at the expense of economic output and full employment? Or do we live with higher inflation for a period of time until some of these issues play out?
Gas prices, for instance, hit a record high in June. The average price per gallon in the US was $5.11 at its peak. The price has since declined to $4.88 per gallon as of July 4th but one year ago averaged $3.22. The reality is consumers are still paying ~50% more at the pump than they were last Independence Day. So although in the short-term we could see some month-over-month relief, we expect inflation to remain persistent and above the Fed’s target well into next year.
At its June meeting, the Fed increased the Federal funds rate by 0.75%, following increases of 0.25% and 0.50% in March and May, respectively. Today there is talk that the July meeting will continue hiking, with projections of 0.75% or 1.00%. As noted in the chart below, the year-end estimates (blue dotted line) indicate continued hikes through 2024. The market’s expectation (green dotted line) diverges from those estimates beginning in 2023.
This divergence in estimates and expectations do not reflect investor confidence in the Fed. It indicates central bankers may go too far and trigger a recession, then reverse course and begin easing again next year.
So, what does all this mean and what are we doing about it?
The S&P 500 peaked on January 3rd, as the Fed made their intentions clear that rate hikes were on the horizon. Since then the index is down 20% year-to-date.
The steep rise in bond yields caused most asset classes to decline in the quarter, further reflected in year-to-date and 1-year returns. US equities entered a bear market (defined as a 20% peak to trough drawdown) and the Barclay’s US Aggregate Bond Index followed up the worst quarter in its history (Q1-2022), with the worst 6-month and 1-year periods in its history.
Diversification is the foundation of building durable portfolios, but clearly the traditional methods have not worked thus far in 2022. Stocks and bonds normally have low price correlation and it is abnormal for them to have such poor returns concurrently. Since 1980 the Bloomberg US Aggregate Bond Index was positive in 38 of 42 calendar years and in the eight calendar years when the S&P 500 was negative, bonds were positive. We still believe a diversified portfolio is the best strategy to reduce volatility and achieve superior risk-adjusted returns.
This is our third bear market in five years. Despite these set backs, the S&P 500 index has managed to return an annualized 11.3% over that period. Both developed international and emerging market equities have much lower 5-year results, partly due to the strength of the US dollar.
For the first time in twenty years, the US dollar is now at parity with the Euro. A strong dollar is good if you plan to travel abroad or buy a German car, but is a headwind for multinational companies and our foreign equity investments. The currency impact for converting developed international equity returns into US dollars, for example, was -8.4% year-to-date.
The following chart shows the historical forward price-to-earnings ratio of the S&P 500. We’ve discussed this topic in past letters, but as a reminder, valuation multiples indicate how much investors are willing to pay for a company (stock) based on its future earnings. For example, at year-end 2021, you could buy Ford stock at 5 times their (then) current earnings or Tesla at 216 times.
Current economic issues have reduced expectations for future earnings. Valuations have contracted over 27% year-to-date. This contraction has not been evenly distributed across all asset classes. Large cap growth and tech stocks have been hit the hardest and although their returns have suffered more than the broader market, they still trade at above-average valuations. These sectors could feel more pressure should interest rates continue to rise.
There are a few important inflection points impacting today’s market. Central bank liquidity was critical for stabilizing markets and the economy during both the Great Recession and the coronavirus pandemic, but it also pushed valuations for many risk assets towards the extreme. It’s natural that this unwinding and shift to a tightening stance in monetary policy would create a valuation “reset” for sectors trading at high valuation multiples.
Current valuations are certainly more attractive than six months ago. Valuations today are below their 25-year average which should result in better returns in the long-run, especially once some of today’s issues subside and market sentiment shifts.
Absent a deep recession, it’s possible the worst could be in the rearview mirror. We believe that whether or not the US economy experiences a recession, market volatility will remain high and the previous lows may be revisited or exceeded. Recessions abate when the underlying economic concerns are corrected. Bear markets end when market sentiment shifts. Where the market goes from here is heavily determined by factors that unfortunately we don’t have an answer to.
What we do know is that these issues will come to pass. Although near-term risks seem evident, we will never bet against long term US economic and capital market growth. Twenty years ago, the US was recovering from the dot.com recession. There have been two economic recessions since yet the market has grown at an annualized rate of 9.2%. An investment of $100,000 invested in the S&P 500 over that time period would be worth $581,000 as of June 30, 2022.
That context of investment time horizon is important. The pandemic recovery of 2020 was the fastest on record for any recession and the v-shaped market reaction was anomalous. We think a three to five year recovery period is a reasonable expectation based on today’s valuations. On the conservative end, a five year recovery to the market peak of January 3rd would result in an S&P 500 annual return of 6.6%. If it takes just three years, forward annual returns increase to 9.9%.
We are systematically rebalancing portfolios towards long term strategic asset allocation targets. In addition, hedged equity positions are being sold in favor of long-only equity or other asset categories consistent with each clients’ investment objectives.
In addition, with the rise in interest rates, fixed income yields are significantly above their 10-year average, with many sectors near 10-year highs. Most corporate and municipal balance sheets remain healthy which reduces credit risk should there be an economic recession. When inflation does eventually subside, bond returns will benefit from declining interest rates.
Last, downside volatility creates opportunities for tax loss harvesting, which is the practice of selling securities with unrealized losses and buying a nearly identical security to remain fully invested. Harvested capital losses can offset capital gains this year or carried forward to future years, enabling more tax efficient long term portfolio compounding. We continually monitor portfolios for these opportunities, and where appropriate, you can expect we will take advantage of them.
We are grateful for your trust and confidence. If you would like to review your financial plan, or investment portfolio please do not hesitate to reach out to us. We welcome your questions and will be responsive.
Jack, Phil and Lauren