Investors Prepare for a Deep Freeze this Winter

Dear Clients and Friends,

Investors have suffered a string of challenges this year including rising concern for European security, energy prices, and the possibility of a recession this winter. While the U.S. economy and job market remain intact for now, stock and bond prices have plummeted as investors sell ahead of a potential decline in economic growth and corporate profits. Stocks are down about 1% in the third quarter, but are off ~21% for the year, as both investor sentiment and expectations for future profits deteriorate.

In the bond market, Fed efforts to rein in inflation have driven interest rates higher, triggering a broad-based sell-off in the bond market that pushed the 10-year Treasury above 4% for the first time since 2008. With yields up and prices down, the Bloomberg Aggregate Bond Index, which tracks a basket of high-quality government and corporate bonds, is down ~14% year to date. Historically, bond performance tends to follow a different cycle relative to stocks, providing a diversification benefit. However, this year’s steep rise in interest rates has depressed bond prices while stocks are also suffering from a significant downturn.

Equities became more volatile during the third quarter. Falling gas prices this summer may have led investors to believe that fading inflation would result in less aggressive Federal Reserve actions. But after reasserting its mission and signaling further rate increases, volatility returned in recent weeks sending the VIX (also known as the “fear index”) above 30; markets careened from optimism to pessimism.

Relentless Fed

The Fed’s primary goal is to slash inflation from red-hot levels reminiscent of the early 1980s. Falling commodity prices are starting to reduce inflation, but our sense is the Fed is highly concerned that a labor shortage and excess demand for workers could poison the economy with long-term systemic inflation.

In past inflation cycles, the Fed has raised interest rates, which in turn led to a hiring slowdown and higher unemployment. These actions have historically resulted in reduced demand across the economy, which ultimately eased inflationary pressures. In this most recent Fed tightening cycle, it seems the job market is an immovable object. Our concern is that the Fed will push too far, leading to more volatility for bonds and equities. Rising yields will continue to put pressure on fixed income prices, while also pulling investors from high-growth equity sectors that become less attractive with higher interest rates.

What’s next?

Late 2022 and early 2023 will likely see a continuation of Fed interest rate hikes and bond sales—a reversal of the accommodating policies that began in the wake of the Global pandemic. Fed tightening actions should continue to cool the economy and lead to depressed corporate earnings. However, rising stock market volatility suggests that investors are struggling to quantify the scale of a potential earnings cliff. Deflating asset bubbles such as the dot-com bust and the Great Recession saw earnings cut in half, although we’ve also seen more “modest” recessions that result in more narrow cuts and swifter recoveries.

Over the past two years, we saw asset bubbles come to a head in the cryptocurrency markets, SPACs, and meme stocks. While the eventual deflation of these investments was harmful to investors who speculated on their valuations, the scale of these declines was relatively insignificant compared to the size of broader and deeper markets. While it remains to be seen whether additional “bubbles” arise, there is little evidence of a severe market dislocation à la 2000 or 2007.

Speaking of recessions, many investors are wondering if we are already in one. Blistering inflation and declining gross domestic product (GDP) have crippled the economy for much of 2022 with the threat of 1970s style stagflation looming. Still, despite the gloom and doom scenarios, the job market continues to grow. We anticipate that cumulative pressures from Fed rate hikes will eventually lead to a recession, which will certainly lead to job losses. However, under current circumstances, we see low odds of a 1970s-style stagflation with massive unemployment.

Investing through the cycle

On August 26 Jay Powell warned that higher interest rates and an economic slowdown would “bring some pain to households and businesses.” But investors are getting restless and asking how long the pain will last. Investors generally consider a market decline of about 20% to be a bear market. In a “run-of-the-mill” recession, we might see a bear market bring stocks down about 30% with recovery beginning in about a year. Asset bubbles typically see a more significant decline lasting about two years.

What catalysts could reverse the bearish trends? In the U.S., retreating headline and core inflation numbers could lead the Fed to pause, significantly improving investor sentiment. Additionally, if companies demonstrate an ability to maintain profit estimates, valuations will begin to look more reasonable. Beyond the U.S., a shift away from COVID lockdowns in China and some form of settlement in the Ukraine-Russia conflict could also help bring the bear market to an end.

While global events continue to unfold, we are focusing on how and where to position through the next phase, which is really the only factor we can control. We have been taking advantage of rising interest rates by buying attractive bonds, anticipating that, at some point in time, interest rates are likely to decline—potentially as soon as next summer. We are also taking advantage of volatility in the equity markets to trim outperformers and add to high-quality stocks on sale.

Given our expectation for continued volatility, should your personal situation require a higher level of near-term liquidity for an upcoming large purchase, we encourage you to reach out to your Portfolio Manager to discuss your needs. In the coming weeks and months, we will remain flexible as we evaluate upside opportunities and downside risks. Our disciplined approach to fundamental analysis, research, and portfolio management continues to uncover opportunities that meet our core investment principles, remaining ever mindful of your goals and objectives.

We wish you all the best this Fall.
Michael Bailey, CFA, Director of Research
Michael Mussio, CFA, CFP®, President

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