- Capital markets continue to demonstrate volatility with a downward bias, particularly stocks
- We recognize recent asset price weakness; however, we must stay vigilant for signs that consumer or business activity is weakening
- Some recent positive performance from traditionally defensive bonds is an encouraging development for diversified portfolios
Current capital market volatility reflects an investment environment adjusting to a forward path driven by two interrelated variables: Inflationary pressures and global central banks’ response. Since 1913, quarterly inflation as measured by the Consumer Price Index has averaged 3.3%, and since 2000 has averaged 2.4%. For the 10 years that preceded the COVID-19 pandemic, inflation averaged a mere 1.7%. More recent readings have exceeded 8% at the consumer level and more than 15% at the producer level, significant increases over long-term averages and levels not seen in decades.
Since the pandemic’s outbreak, central banks and policymakers have had to toggle between policies designed to promote growth and economic activity (accomplished by lowering target interest rates and purchasing assets, which in aggregate decrease borrowing costs) and now to thwart inflationary pressures driven by both robust economic growth and supply chain shortages across industries. Facing material decreases in consumer and business demand during the pandemic’s depths, the U.S. Federal Reserve (Fed) and other central banks slashed interest rates, bought bonds and other assets, provided liquidity facilities and communicated ongoing support as the economy regained its footing. More than two years later, despite mixed global economic growth, central banks have shifted their focus toward restraining price increases given the challenges they pose to businesses and consumers.
One of the core underpinnings girding global finance is interest rates drive asset prices. Very simply, if interest rates on U.S. government-issued bonds (backed by a central body with a stable government, taxing power and a strong military) increase, all other assets reprice lower in response — at least in theory. As an example, fictitious company Acme Incorporated may issue bonds to prospective lenders. While Acme may have a solid balance sheet and a diversified set of products, it does not have the ability to tax investors. Therefore, comparing a U.S. government-issued bond maturing in five years to an Acme bond maturing on the same day will assign a higher risk factor to Acme. That higher risk factor manifests in a higher interest rate for the Acme bond over the U.S. government bond. Should the interest rate on the U.S. government bond increase, the price on the Acme bond would fall to reflect that increase in the prevailing interest rate.
Since central banks have already increased their target interest rates or signaled their intentions to do so (along with, in some cases, starting to reduce their accumulated bond portfolio purchases), all existing bonds paying interest set by older and lower rates should in theory reprice to the newer, higher interest rate regime. Bonds reprice by moving down in value, which causes them to yield more than they did at the previous higher price. Repricing activity is not limited to the bond market; as interest rates rise, stocks, real estate, commodities and other assets in theory should move lower in price, and that is what we have seen this year. Exceptions are parts of the commodities market tied to energy prices, which have benefited from tight supplies and steady demand. While some central banks, including Europe and the United Kingdom, have offered mixed forward guidance on interest rates, the Fed has been clear with its intentions: Interest rates will increase until the Fed sees signs of inflation abating, reiterated yesterday by Chairman Jerome Powell during a virtual event with journalists.
Despite these communicated intentions, asset prices (perhaps most visibly stocks) continue to demonstrate volatility with a downward bias in price. The last two trading days saw domestic stocks as measured by the S&P 500 rally by more than 2%; today the same index closed down 4% and at the lowest closing level of a turbulent year. Technology stocks, consumer-sensitive sectors and other categories continue to demonstrate pronounced weakness. Why, if the Fed and other central banks have already indicated their intentions to raise interest rates, do these weak asset price trends persist? The S&P 500 is down more than 17% year to date and the tech-heavy NASDAQ is down more than 27%. Isn’t that enough of a “repricing” lower?
While no one knows when repricings higher or lower end definitively, the recent and persistent weakness speaks to the growing risk of a second asset repricing, driven by more than the Fed fighting inflation. This repricing would reflect markets discounting an economic and corporate earnings slowdown not currently reflected in prices, led by consumers hampered with rising mortgage rates, elevated and sticky energy costs and higher food prices. Additionally, businesses would be under pressure from higher costs of capital, weakening margins due to higher wage and shipping costs plus uncertainties about inventories. Some recent corporate earnings reports have amplified these concerns as becoming realities. While a second repricing isn’t our base case, we continue to monitor volatile price movements and remain alert for any signs of weakening consumer or business activity.
Typically, policymakers counteract a weakening economy with countercyclical fiscal spending or pro-growth monetary policy. The Fed is unlikely to change to more accommodative monetary policy given inflationary pressures, and the U.S. House and Senate passing a large spending package with slim majorities in a contentious election year is an equally unlikely outcome. Markets discount today what they anticipate about tomorrow, so investors are expressing concerns about how businesses and consumers will hold up if inflationary pressures continue and the Fed decides to increase interest rates beyond their signaled intentions.
As we discussed on a recent client call, we are encouraged that the bond market is showing signs of stability and helping to at least partially offset some of the equity market downdraft, although that is a relatively recent phenomenon. We are mindful that, on average, domestic equity markets have downdrafts on the order of 14% to 16% at some point intra-year over the past 30 years, but those reminders can sometimes offer little solace during periods of uncertainty. We are seeing some very attractive opportunities for patient investors, but we respect the nature of the current repricing scenarios among a heavy news cycle.
As always, engaging with your wealth management professional to discuss your unique financial situation is our best perspective and, as always, please do not hesitate to let us know any questions you may have.
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