July 28, 2022

The financial market rollercoaster that we have all been on over the course of the last seven months has been tough to stomach even for the most seasoned of investors. Our collective anxiety is warranted given that the S&P 500 just had its second worst start to a year in history, and bonds are also having their worst year in decades. Apart from commodities—which delivered decent returns in the first half of the year—investors have recently been left with little to no options to generate positive real returns. 

As hard as it can be to maintain one’s resolve during times like these, it is important to take a step back and recognize that financial markets have already significantly corrected. Moreover, markets are forward looking, and broad fears of recession have been present for much of the last six months causing many to suggest that this could be the most anticipated recession in history. And yet, even though there is risk that a recession may develop, in our view, it is not a forgone conclusion in the short term. 

The rule-of-thumb definition of a recession is two consecutive quarters of declining GDP. This has been used because it assumes that there are serious underlying problems if contraction persists for two quarters. However, today’s circumstances make this definition harder to justify. GDP declined in the first quarter, but it was negatively impacted by the Russia/Ukraine war. Growth of consumption, employment, and industrial production were strong and not consistent with a recession environment.

The official definition of a recession comes from the National Bureau of Economic Research (NBER), and it is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” In the second quarter of this year, some of these measures began to soften—namely industrial production and real income—as the auto industry, in particular, continued to grapple with supply chain problems and as general inflation outpaced wage growth. In contrast, though, the employment market remained solid and retail sales continued to show ongoing strength. The overall result may be a decline in GDP during the second quarter and it is possible that this volatile moment could be declared a recession. However, it would be a very unconventional recession given the historically robust job market and strength of the consumer. For this reason, and because our forward one-year outlook is for a positive economic environment from here, we have a low-growth outlook rather than a near-term recession outlook. Besides, we see opportunity in both bonds and stocks at this point, even in a mild-recession scenario.

Financial market volatility is almost always unpleasant, especially when it impacts asset classes that have historically provided ballast to a diversified portfolio, but it almost always creates opportunity. With bond prices down as significantly as they are—long duration Treasury bond prices were down more than 20% by the end of the second quarter—our outlook for bonds is beginning to change. Just a year ago, yields were near zero across the yield curve and we viewed bonds as being mainly a volatility dampener but with very little opportunity for them to generate a real positive return. With yields now higher and the possibility that the Federal Reserve could be finished raising interest rates by the end of this year, their ability to generate positive returns has meaningfully improved. Indeed, at the end of the second quarter, we added a new position in a long-term Treasury ETF. This is the first time that we have added to traditional bonds in three years, and we view this position as one that should provide some protection to our clients’ portfolios should a recession officially develop. As the Federal Reserve continues to raise interest rates this year, we expect that short-term interest rates could rise modestly; but with one-year Treasury bonds now yielding more than 3% and the Federal Reserve’s target to raise the federal funds rate to 3.4% by the end of the year, it appears as though most of this is already factored in. Longer-term interest rates should remain near current levels as long-term interest rate expectations are not likely to change materially.

Opportunity is also present in the stock market. Even though we haven’t seen earnings estimates come down this year as many Wall Street strategists have been forecasting, valuation multiples have been significantly reduced which suggests that lower earnings growth projections are being factored into expectations. A recent Bank of America survey showed that investors have reduced their equity allocation to the lowest level since the collapse of Lehman Brothers in 2008. While it is certainly troubling to be grappling with inflation at levels not seen in forty years, the ongoing strength of the job market, the health of the consumer, and the health of corporate America suggest that the economic backdrop now is better than it was in 2008.

Still, valuation alone is not a sufficient catalyst, and financial markets need more clarity on the inflation front and the interest rate outlook before they will likely find their footing and begin to appreciate more meaningfully. We expect that we could be on the cusp of seeing inflation begin to moderate which should also provide more certainty on just how high the Federal Reserve will need to raise interest rates. Commodity prices have recently declined, and the July New York Federal Reserve business survey has shown that prices paid and received are beginning to come down. Many retailers also have too much inventory and are resorting to discounting. We have yet to see this reflected in the Consumer Price Index (CPI), but we expect that this popular inflation gauge will begin to show signs of easing in the coming months. Importantly, though, we recognize that several categories—most notably shelter and rent—may not show signs of easing for quite some time. However, at this point, we feel that any signs of easing would be welcome news.

As always, we will continue to closely monitor financial markets and strive to take advantage of opportunities we see along the way. We understand that these are challenging times, and we welcome the opportunity to discuss our views and your own personal financial plan with you in more detail. Please don’t hesitate to reach out to your Wealth Manager to schedule a time to talk.