Given the volatility in both the stock and bond markets, we wanted to explain what is causing the market dislocations and what we are doing about it. The cause is simple: inflation. Higher prices are rippling through the economy and stock market. In the chart below, you can see changes in prices in different components. The spikes in 2021 and 2022 are quite apparent. Why did we get these spikes? After the height of the pandemic, consumers had not spent money. As the pandemic began to subside, suddenly consumers wanted anything and everything, but could not get many products due to worker shortages and supply chain logistical issues. The result was a huge demand/supply imbalance.
In order to combat inflation, interest rates needed to go higher in order to tamp down demand. Higher interest rates mean the cost of borrowing is higher – for individuals and companies alike. Mortgage rates have ticked above 7%. For those that bought their first home in the 1970s, 7% still seems like a bargain. For those that have been spoiled by the recent environment of low rates, and used leverage to their advantage, 7% seems like a fortune. On a $400,000 mortgage, the monthly payment is $700 higher than it was just over a year ago. Corporations of all sizes use lines of credit or the capital markets to finance their businesses. Those are now more expensive; both have an impact on profit margins. These extra costs will curtail spending (demand) elsewhere.
As interest rates rise, savers/investors can finally see some rewards in fixed income. During the summer of 2020 the 10-year treasury bond had a yield of 0.50%. Today, the 10-year treasury has a rate of 4.00%. That change in rates (bond prices moved lower due to their inverse relationship) finally made bonds somewhat attractive. For the past 10 years bonds were not a great investment due to their negative real yields. While not recommending selling stocks to buy bonds, those with cash can buy bonds and earn a “fair” yield. Of course, if inflation stays in the 8% range those bonds will continue to yield a negative real return. However, it is unlikely that inflation will stay at 8%. We are already seeing signs of inflation starting to ease; energy prices (oil prices in the U.S.) are down 37%, copper is down 33%, lumber is down 71% and the money supply (think printing money) is below 2017 levels.
One of the biggest things to consider is how much is the stock market already discounting. Hard landing? Soft landing? Recession? Mild? Severe? It is important to note that not every outcome is feast or famine. Many times, there is middle ground. However, human (and the media’s) nature often is to focus on extremes.
The stock market is already pricing in some kind of recession later this year or next. See the peak to trough history of the Dow Jones since 1900. This chart shows that the stock market is extremely resilient and has rebounded each and every time after a recession. The latest major recession in 2008 looks like a minor blip in retrospect – although living and working through it was extremely challenging.
The S&P 500 is down over 20% in 2022. In the chart below, view the calendar year performance of the S&P 500 going back to 1950. Almost 80% of those years has returned a positive return. There have only been two times during that period where the stock market returned negative returns in consecutive years – the oil embargo of 1973-74 and the tech bubble coupled with 9/11 in 2000-02.
Finally, during times like this it is important to get back to the basics – asset allocation and a long-term outlook. We are investors, not traders. The final two charts show the difference in returns when looking at a 1-year period vs. 5-year period (longer term) with different stock/bond ratios. You will note the much lower negative (red) lines on the 5-year chart compared to the 1-year. While not pleased with the past nine months of stock market returns we have been here before. We like what we hold and will continue to evaluate our positions as the inflation and interest rate landscape evolves. It is important not to panic, own high-quality investments in companies with strong balance sheets and cash flow, do not try to time the market, and review your individual plan – remember that we always account for situations like these in our plans.