Key Questions: Persistent Inflation Provokes a Bear Market. What’s Next?
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Investors may be facing a “financial hurricane” but the best strategy may be to remain calm as the storm comes to shore.
For the past few weeks, many economists and market participants expressed hope that the inflationary pressures that emerged last spring would begin to ease. “Inflation is peaking” was a consistent refrain. These hopes were abruptly dashed last Friday when the Bureau of Labor Statistics revealed that prices at the consumer level unexpectedly rose 8.5% in May, more than anticipated.
The increase was the fastest pace in four decades. It was also broad based with many segments of the economy exhibiting uncomfortably high levels of inflation, including fuel, food, housing, cars, airfare and electricity. In sum, May marked the 13th consecutive month of inflation, exceeding the target rate of the Federal Reserve (the Fed) and, in many cases, considerably so.
Legendary investor Warren Buffett is attributed with saying that “inflation swindles almost everybody.”
Based on what many of us are experiencing in our daily lives, that statement is hard to refute. Inflation hurts nearly every consumer and company. Lower-income individuals are especially harmed and often must forego spending on various items as the prices of necessities such as food, shelter and energy require higher outlays.
Financial assets are also adversely affected by high inflation, a topic we’ve addressed in prior communications. Rising inflation typically forces policymakers such as the Fed to raise interest rates in order to raise borrowing costs in an effort to cool demand. As interest rates rise, bond prices fall. Stock prices also come under pressure as the discount rate used to value stocks also rises, causing the value of future cash flows to decline. Companies whose future cash flows are far into the distance (often referred to as long duration or growth stocks) see their stock prices fall harder than those companies whose cash flows are more certain (i.e., short duration or value stocks).
Until recently, the selling pressure experienced in the equity market this year had been centered around growth stocks with many registering declines of 50% or more. Lately, however, the selling pressure has broadened and as of Monday’s close, the S&P 500 Index has fallen more than 20% from its previous high, an event most market observers characterize as a bear market.
Natural Part of Business Cycle
It may seem hard to believe, but today’s bear market is the second we’ve faced in the past two years. It is the ninth since 1980 and the 14th since 1950.
In other words, bear markets occur every four to five years. And while most people find them painful, they are a natural part of the business cycle. They also provide investors with an opportunity to earn excess returns once prices stabilize and eventually trade higher as anxieties fade. As another famous investor once remarked, “Bull markets are born on pessimism.”
It is worth noting, however, that this year’s bear market is different from the last in one critical respect: Unlike the aggressive path the Fed took during the bear market of 2020 to cushion the blow from COVID-19 by injecting tremendous liquidity into the economy, today the Fed is doing the opposite. Interest rates are poised to rise considerably and the Fed is draining liquidity.
So Where Does This Leave Investors?
In the short run, volatility is likely to persist given elevated levels of uncertainty over just how aggressive the Fed will be. In addition, earnings estimates for the balance of 2022 and 2023 are likely too high and probably will be revised lower. This could put further pressure on stocks.
Meanwhile, despite inflationary headwinds facing consumers, many households accumulated significant savings that can be used to support spending. Corporations are also generally well off and the financial sector appears to be well-capitalized. Also, with the economy still enjoying healthy momentum, earnings estimates may not fall too much so long as such economic momentum endures.
Stay Calm in Face of the Storm
Some have commented that investors today are standing in the path of a “financial hurricane” given the myriad of challenges we face. Such a metaphor captures the market zeitgeist extremely well.
We are indeed facing challenges on many fronts ranging from inflation surging to multidecade highs, tense geopolitics and the prospects of a slowing economy spurred by financial conditions that are quickly tightening. For these reasons, it is indeed time for caution, prudence and discipline.
But at the same time, should a hurricane come crashing ashore, we would note that despite short-term disruptions brought about by violent weather, such events inevitably pass. Economic activity recovers, shoreline and infrastructure are repaired and the underlying foundation is refortified.
Thus, we continue to believe that while investors should brace themselves for further volatility, those who prudently take measures to build and maintain resilient portfolios will be rewarded whatever events come their way. This does not mean that investors should idly sit on their hands. Rather, they should carefully reassess what they own (and why they own it), consider making modest tactical adjustments as necessary and adhere to their long-term investment plans, which likely were written amid calmer conditions, and not abandon them as the waters turn rougher.
Admittedly, despite its best efforts, there is not much the Fed – or any capable policymaker – can do to influence inflation in the short run. The cure for higher prices is typically higher prices. And because demand has been so persistently strong, prices have not been strong enough to squelch demand, hence the need for the Fed to intervene.
Inflation will eventually come under control. In fact, there are already a few signs that consumers and businesses are tempering their enthusiasm for certain purchases. Existing and new home sales, for instance, have slowed. Similarly, wages, while up sharply year-over-year, are also moderating.
As we continue to navigate these challenging times, it is important to note that in each of the post-World War II downturns, the stock market bottomed as the economy was still deteriorating. It is also worth noting that once a bear market decline of 20% or more is recorded – while additional downside is common – prospective returns over a reasonable time period are skewed to the upside. As evidence, in the last 16 bear markets, stocks were positive 12 times one year later and 15 times three years later – ranging from a decline of 6% to an astounding gain of over 100%, and average returns of over 40%. These gains can only be accomplished by staying invested.
Earlier this year, we advised clients to reduce a longstanding overweight to equities and align their allocation to equities with their strategic targets.
This resulted in adding to cash reserves for the purpose of providing some dry powder. We continue to recommend holding some safe and liquid assets to ride out today’s market turmoil, but long-term investors should use this downturn to add judiciously to stock positions. Modest allocations to Real Assets and select Alternative Strategies can provide for enhanced diversification benefits in certain instances as well.
All said, we believe investors should select an asset allocation strategy that can be sustained through a bear market and even an economic downturn. But for this strategy to be successful, it should be maintained.
For more information, please contact your advisor.
About George Mateyo
As Chief Investment Officer, George Mateyo is responsible for establishing sound investment strategies for private and institutional clients, expanding internal and external research capabilities, and managing the delivery of solid risk-adjusted investment performance.
In previous roles, George spent more than 15 years in investment management and investment consulting, where he acquired firsthand knowledge and insights into the capital markets and the stewardship of investment portfolios for institutional and high net-worth investors.
George received his MBA from the Weatherhead School of Management at Case Western Reserve University and completed additional studies at the London School of Economics.