Shadows And Crosscurrents
After a remarkable market rally in 2020-21 that saw investors largely unfazed by the ongoing pandemic, persistent supply chain disruptions and surging inflation have cast a shadow this year on the economic outlook. Stock prices have dropped meaningfully in 2022, as financial markets began sensing the threat of a looming recession. And with the Federal Reserve pivoting from its ultra-low interest rate regime, bond prices have also fallen.
From pain to gain
This year has rudely reminded us that the trade-off to owning stocks, and the growth they offer, is an occasional correction. Often quite painful, bear markets are an unwelcome yet normal feature of the market cycle. The fact that they generally coincide with ominous headlines renders the environment even more unnerving. Historically, sell-offs may be shallow or severe, but they tend to be short-lived.
Since World War II, stocks had previously endured a dozen bear markets (defined as a 20% drop by the S&P 500 Index). During these periods, stock prices dropped by one-third with a downturn lasting for 12 months, on average. Over the same timeframe, there were 30 other instances in which stocks pulled back by between 10% and 20%.
Likewise, the S&P 500 has seen a dozen bull markets (20% increase) over the post-war period. However, in contrast to the typical bear market experience, stocks have risen 150% with the trend continuing for 60 months, over the average upcycle.
Time not timing
While risk must be borne to achieve return, the longer the holding period, the greater the odds of a favorable outcome. For instance, on any given trading day over the last 100 years, the S&P 500 has produced a positive return a bit more than half of the time — little better than a coin flip. Yet, over 1-year periods, stocks have been up 75% of the time while 90% of 5-year periods have ended with positive stock returns.
Nevertheless, why not exit to avoid the bears and then return to run with the bulls each cycle? In practice, that is an elusive goal. History is littered with pundits who became famous for making one right call in a row. The challenge is that two critical decisions must be timed correctly: Sell stocks before incurring severe losses and then move the chips back in before the rally takes off.
This dilemma is exacerbated by the fact that stock market gains tend to be both unpredictable and lumpy. For instance, a Ned Davis Research study found that over the 20 years ending 12/31/21, half of the S&P 500 Index’s largest daily gains actually occurred during bear markets. And another 34% of the best days took place in the first two months of a bull market — before it was clear that the bear had begun hibernating again.
Back to the future
The pandemic — and the global response that ensued — severely disrupted the supply of many goods and services. In recent months, China’s zero-covid policy and Russia’s invasion of Ukraine have amplified the bottlenecks, the latter producing a sizable commodity supply shock.
Consequently, consumer price inflation spiked to multi-decade highs in late 2021 and has remained sticky, broadening to many categories of goods and services. Policymakers no longer view the threat as “transitory”. The Fed seemed shocked into action following the release of the latest CPI report in June (All Items +8.6%, Core +6.0%), quickly raising the short-term policy rate by three-quarters of a point to 1.75%. Equity markets sold off on the news.
The Fed has fallen behind the curve, necessitating a more restrictive posture. Powell & company are now focused on quickly bringing down consumer price inflation even at the potential cost of recession. Tighter monetary policy aims to tap the brakes on economic growth to relieve inflation pressures.
The central bank now anticipates that the fed funds rate will need to rise to 3.8% by the end of 2023. As recently as December, policymakers had projected a level of 1.6%. The pace and extent of Fed tightening will depend on several factors: 1) How quickly supply-side problems subside; 2) How consumer and business spending react to the tighter financial conditions; and 3) Whether the Fed retains its credibility as an inflation fighter, particularly if inflation takes a while to recede.
As Jerome Powell himself has acknowledged, Fed policy influences the demand side of the economy; it cannot really affect supply conditions. Powell is powerless to wave a wand and ameliorate the shortages of oil, grains, semiconductors, and Sriracha. And as he remarked in a recent interview, “…whether we can execute a soft landing or not…may actually depend on factors that we don’t control.”
The Fed has become concerned that consumers’ long-term inflation expectations may take off. Such a reset would ratchet up long-term interest rates. The experience of the 1970s shows that when expectations become “unanchored”, they may become self-fulfilling, or in the words of former Chairman Paul Volcker, “inflation feeds in part on itself”.
So far, expectations have remained moored. According to the University of Michigan’s closely watched survey, consumers now expect inflation to rise at a 3.1% annual clip over the next five-to-ten years. That is up from their long-term outlook before the pandemic, but in line with surveys from the prior two decades. Additionally, bond market measures of long-term inflation expectations are also still at reasonable levels.
Ebb and flow through
Meanwhile, there are signs that some price pressures are ebbing a bit. Although still elevated, prices of many commodities have dropped significantly. For instance, copper is trading at a 19-month low while lumber and wheat prices are down 40% after spiking in early 2022.
On the logistics front, shipping rates have begun trending lower. After more than two years of chronic delays, container shippers are finally seeing continuing improvements in both transit times and port delays, according to Drewry Shipping Consultants. The number of cargo ships in queue outside the ports of Los Angeles and Long Beach has fallen dramatically.
Fed policy has started to cool down one overheated sector — housing. Over the last six months, the rate on a 30-year fixed rate mortgage has nearly doubled, now standing at almost 6%. Many real estate markets remain tight, but the higher cost of borrowing along with surging home prices may act as a relief valve. Mortgage applications have dropped and the inventory of homes for sale has crept up. Redfin reports that the share of homes for sale with price reductions continues to rise; those with multiple offers have diminished.
More solid footing
Inflation will ultimately come down to more palatable levels, one way or another. For investors, the question is whether the Fed will need to continue to move aggressively to restore price stability. If so, the central bank will end up engineering a recession. And as the economy contracts, corporate earnings will come under pressure. The potential threat of this scenario explains much of stock market’s malaise this year.
However, the economic backdrop suggests that any recession that did ensue would be relatively mild. Consumers have a larger margin of safety than in prior cycles. Total household net worth stands at $150 trillion, up 25% from pre-pandemic levels. Consumers hold $18 trillion in cash compared to $14 trillion in early 2020. Household debt relative to disposable income is one-third lower than it had been prior to the 2007-09 recession. And on the labor market front, there are still almost two job openings per unemployed worker.
The critical housing sector is also on more solid footing despite some of its froth. Unlike 2007, the vacancy rate is very low; there is no glut of unoccupied homes. The vast majority of homeowners have built up equity. Those with mortgages typically have fixed rate financing at low rates. Importantly, the quality of mortgage lending has been very high post-2008, as evidenced by much greater median FICO scores.
If inflation begins to decline meaningfully over the coming months in response to easing supply constraints and weaker economic growth, the Federal Reserve could push the pause button. Financial markets would view that outcome favorably. If, instead, broad price pressures persist, markets will maintain their choppy behavior. Either way, history demonstrates that the longer-term trend is upward.
Christopher J. Singleton, CFA, Managing Director
July 13, 2022