NEWSLETTER: All Eyes on the Fed
Second Quarter 2022 Market Summary:
- High inflation is driving the Fed to raise interest rates, which in turn is causing volatility in stock and bond markets
- Unemployment is low and job market growth is robust
- Recession timing is up for debate, but we expect any recession to be mild
- Stocks appear cheap relative to 25-year averages, however caution is still required
- Investors should maintain discipline and stay the course to achieve their long-term goals
Markets came under continued pressure in the second quarter as investors weighed the risk of higher interest rates and the probability of a recession. Both stocks and bonds recorded losses, with the S&P 500 index closing the quarter down -20.58% year-to-date. Not all was negative, though, as the job market remained robust. The economy added an average of 488,000 new jobs per month through the first five months of the year.
All eyes will be on the Fed at its next meeting on July 26-27. The market widely expects the central bank to increase its target federal funds rate by 75 basis points (0.75%) to a target of 2.25%-2.50%. Higher rates have weighed on stocks and bonds as the Fed has been hiking quickly to combat record inflation stemming from the effects of the pandemic and the ongoing Russian war in Ukraine.
Investors are currently wondering if we are heading for recession, or if we are in one as we speak. The National Bureau of Economic Research (NBER), the body which determines and dates recessions, defines a recession as "a significant decline in economic activity that is spread across the economy and that lasts more than a few months." Given that definition, it's up for debate as to whether we are in a recession. If second-quarter GDP is negative, some may declare a recession, while others may point to low unemployment and robust job growth to suggest otherwise.
Nevertheless, there are indicators that suggest the next recession may be mild. The market does not face the excess corporate and household leverage that it did in 2008, nor do we expect the government to shut down the economy as it did during the pandemic.
For long-term investors, we do see opportunities in stocks. Valuations have fallen from their 2021 peaks as interest rates have risen. The forward price-to-earnings ratio (PE) of the S&P 500 has fallen by 27%, from 22x to 16x, which is below the 25-year average of 16.85x.
Stay the Course
Even though stocks are cheap compared to recent history, we are continuing to take a balanced approach to portfolio construction. After all, valuation on its own is not a great timing tool. We are focused on quality companies and lower duration fixed income allocations to defend against rising rates.
In volatile times like these, we believe investors are best served by maintaining discipline and focusing on the long-term view. We construct portfolios with clients' long-term goals in mind, and we expect to weather rough seas from time to time. We will continue to evaluate opportunities to reallocate portfolios as the investment environment warrants, and in taxable accounts, we are actively looking to take advantage of volatility by tax-loss harvesting.
It is important to remember that markets are a discounting mechanism. Every day, market participants debate on today’s value of tomorrow's earnings with millions of buy and sell transactions. Collectively, the market uses all available information to look forward and agree on the "right" price. This means expectations of future good or bad news are "priced in" well in advance. So, while the economy might not yet be feeling all the effects of higher interest rates, it will in the future, and the market is anticipating those challenges. And when we do experience them, the market may very well be looking ahead to economic recovery.
Feel free to contact us if you have any questions.
Please be advised that the contents of this post is for educational purposes only and should not be understood as investment advice.