Investment Outlook Fall 2022

By Argent Wealth Management, LLC on October 7, 2022

Do The Fed Governors Have an Ego Problem?  Because It’s All About Them!

Third Quarter Review, Fourth Quarter Outlook:

If the year ended September 30, this would be the worst year of combined stock and bond performance since 1941.  There are only two years on record since then where both the S&P 500 and Long-Term Treasury Bonds (LTTB) were both negative, according to Ned Davis Research.  In 1969, the S&P 500 was down 8.5% and LTTBs were down 5.1%.  In 1973, the S&P 500 was down 14.8%, and LTTBs were down 1.2%.  Year-to-date (YTD) the S&P 500, as represented by SPY (an ETF tracking the index), is down 24.8% and LTTBs, as represented by IEF (an ETF tracking 7-10 Year Treasury Bonds), are down 15.65%. 

At the beginning of 2022, few, if any, predicted CPI would be over 9%; yet this has caused a historically bad 2022, so far, for stock and bond markets. COVID-19 created some supply chain bottlenecks in 2020 and 2021 as countries around the world shut down manufacturing periodically.  Although some of these issues eased towards the end of 2021, many still lingered.   Making matters worse, China has continued its zero-Covid policy shutting down cities that are key hubs in global supply chains.  Russia invaded Ukraine.  This exacerbated global supply chain issues, especially for energy and food. 

Meanwhile, consumer balance sheets were and remain strong, so aggregate demand has stayed steady even in the face of increasing prices.  Strong demand in the face of limited supply led to the highest inflation since the early 80’s.

Inflation erodes the value of the dollar compared to goods and real assets.  Ultimately, if inflation is persistently high and not controlled, individuals and investors no longer trust the fiat currency system. Without trust in the system, the economy will collapse.  This has happened to countries such as Zimbabwe and Venezuela. 

Therefore, it is no surprise the Federal Reserve (the Fed) has been hawkish, determined to bring inflation down towards it’s 2% target.  Partly due to their efforts and rhetoric, the dollar remains the reserve currency of the world, and it has strengthened in 2022.

In a way, this is a vote of confidence in the Fed.  Inflation is defined by a loss of purchasing power, and, compared to other countries around the world, the U.S. Dollar has not lost purchasing power.  But the Fed has a difficult job ahead: bring down domestic inflation while minimizing damage to the economy.

In hindsight, the Fed should have been increasing the Federal Funds Rate (FFR) last year.  Increasing the FFR increases the cost to borrow for mortgages, car loans, business loans, or anything debt related.  As the cost to borrow increases, the cost to purchase or invest increases reducing aggregate demand (which is disinflationary) in the economy, or vice versa. 

In 2021 the S&P 500 was up over 28%.   A zero-interest rate policy helped lead to excess speculation.  This year, most of those gains have been erased.  If the Fed had embarked on a slow path of rate hikes in 2021, it would be easy to hypothesize that we could have avoided the quick boom and bust that we have faced.  This has been a fast rate hike cycle.  As the chart shows below, stock markets do better in slow rate hike cycles than in fast rate hike cycles.

Global investors in some ways, as can be seen with dollar strength, have given a vote of confidence to the Fed.  But in other ways, the market is unsure if the Fed can engineer a “soft landing” (reduce inflation with no recession). 

There is good reason for investors to be skeptical.  CPI is backward looking.  It tells us what has happened with prices not what is happening or what will happen.  Yet the Fed relies on CPI to make policy decisions.  To make matters worse, many estimate that Fed policy decisions don’t truly impact consumer behavior for 6-9 months.  So, the Fed is enacting policy, of which the effect is unknown for many months, relying on data that is backward looking.  No wonder stock and bond investors are skittish.  VIX has been persistently high, and pessimism is also high. 

The good news is that volatility creates opportunity.  Stock markets, as can be seen the “NDR Daily Trading Sentiment Composite,” tend to do go up 23.67% on average since 2006 when pessimism is high.  “Buy when others are fearful” is the adage many quote.  

What’s Next?

Typical bear markets are “W” shaped.  There is an initial decline (step 1), followed by a rebound (step 2), followed by a retest (step 3), followed by the start of a new bull market (step 4).  Around June 16 the S&P 500 made its initial low in this bear market.  The S&P 500 rebounded ~17% before plummeting again to around June lows by September 30.  Is the recent sell-off a retest, meaning we are on step 3, or are we still in the middle of the initial decline (step 1)?

The answer to this has significant implications.  If we are on step 3, investors could expect the bear market to end sometime in the next couple of months.  This would not be too surprising.  We are in the worst seasonal period for stocks in the worst year for stocks historically within the four-year presidential cycle (this year is the mid-term year).

This chart shows the average return of mid-term years, and the subsequent returns post mid-term years going back to 1928.  In addition, you can see it is typical for stock markets to hit lows in the fall before rebounding.

Despite historical analysis that indicates that high fearfulness and stock market weakness are more often expected in the fall of midterm years, history does not always repeat, and ultimately the fate of the market will be determined by Fed policy. 

Fed Policy and Inflation

Below you can see the expected FFR for May 2023.  Current investor expectations (blue) are above June investor expectations (yellow).  However, current investor expectations are below last week’s investor expectations.  Last week ending September 29^th, the S&P 500 was down ~3%.  Jerome Powell, the Chairman of the Fed, stated in the middle of his last press conference in mid-September that they would be keeping an eye on financial conditions (a way of saying stock and bond markets).  As discussed previously in this quarterly, the Fed has a very difficult job.  They are using backward looking data to enact policy that doesn’t impact behavior for months in the future.  One way the Fed can counteract this problem is by paying attention to financial conditions, such as stock markets, that are 6-9 months forward looking. 

According to Ned Davis Research, the average bear market decline is -31% over 299 days.  These types of declines are usually associated with a recession.  Therefore, if the S&P 500 was to go down another 5-10%, nearing 30% down for the year, it would essentially be predicting more than a mild recession sometime in the next six months.  Recessions are deflationary.  The Fed Governors should get the message that they have gone far enough, or even too far, in their quest to control inflation. 

Aggregate demand would suffer, and unemployment will rise too much.  Economic damage would be high.   Therefore, Fed may and should look to these financial conditions as a reason to become more dovish.  It is no surprise then that the S&P 500 was down 3% the week ending September 29 and expectations for the FFR decreased.  A more dovish Fed, with expectations for a lower FFR, would likely be positive for stock and bond markets just as a more hawkish Fed, with expectations for a higher FFR, would likely continue to be negative for stock and bond markets. 

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