When asked if I want the “good news” or “bad news” first, I almost always choose the bad first. Maybe it’s a personal thing, but I think many of you reading this would agree with me. You get the ripping of the band-aid over with, and it tends to make the good news feel even better.
Counter to this, even though it has been delivered first, the market seems hesitant to accept the bad news (inflation is high and is not coming down fast enough). Instead, it seems focused on hopes of a Fed “pivot” or reversal of their tightening campaign. Investors drove the market higher through most of July and August on hopes such as these. However, the bad news – in the form of good news on the job front – just kept coming.
At the heart of the volatile markets, this year has been this split opinion on how aggressive the Fed will be in fighting inflation. Early on, the consensus was that the Fed would be more pragmatic in their inflation fighting campaign – meaning they would go slowly and allow inflation to come down on its own. Through recent actions and messaging to market participants, the Fed has made it clear that they will seemingly remain vigilant in their mandate to bring inflation down through more interest rate hikes.
This is why I mention that good news on the employment front (more jobs being created than expected and less unemployed than expected) has been bad news for the market. The Fed, while not explicitly saying it, needs unemployment to go up (more people losing their jobs) for inflation to come down. A strong job market seems to have given the Fed even more leeway to continue raising rates.
What does this mean for interest rates and the market going forward?
First the not-so-good-news: We expect the Fed to continue tightening. This may mean more market volatility, more downside pressure on stocks and more chance that the U.S. dollar will continue appreciating. We also expect inflation to come down over time, but maybe not as fast as the market expects.
Why has the strong dollar been a challenge for markets? Mostly because it makes things priced in dollars worldwide more expensive for foreigners. This includes energy, dollar-denominated debt and U.S. imports.
Now the good news: Investors that have exposure to fixed income can now buy bonds at much, much higher yields. As laddered bonds mature, or as new money is put to work, BSW is seeing yields in some cases that are 3x what they were at the end of 2021!
In addition, this recent market sell-off has triggered our downside rebalancing target. This means BSW will be trading in certain client accounts over the next few weeks in the hope of buying stocks at cheaper valuations. To be clear, we are not overweighting stocks for clients– we are simply getting clients back to their long-term macro asset allocation target. We will do so again if the market falls another 15% from where we ended September. Historically, buying stocks when they have entered a bear market has been beneficial 1-2 years hence.
In the above chart, the red dots symbolize intra-year market declines. Singling out all the ones that are -20% or more, you can see that subsequent years are almost always firmly higher. Another few points to highlight are: 1.) The number of down 20% or more bear markets are the exception, and 2.) despite so many intra-year market declines, most of the periods finish in the black.
BSW also is using this rebalancing period to shift our stock exposures slightly. Overall, we are attempting to take a more defensive stance. Within BSW traditional growth portfolios, we are reducing our emerging markets exposure, underweighting developed foreign stocks and increasing our exposure to large cap U.S. value stocks specifically. Value stocks have tended to perform better during higher inflationary periods and periods of potential earnings deceleration. Since value stocks generally tend to sell at lower PE multiples, they should not be as vulnerable to sell-offs following an earnings shortfall.
As I look out my Boulder, Colorado office window, I am reminded that seasons often change quickly. Just last week the trees surrounding the office were deep green and full. Today they are a kaleidoscope of yellows, oranges, and reds.
The markets also have seasons. Prior to the pandemic in 2020, the economy experienced the longest expansion in U.S. history – this, according to the national Bureau of Economic Research, lasted 128 months.
However, it is easy to forget that prior to the economy shutting down for health reasons in 2020, the leaves were already starting to turn. U.S. GDP in the first quarter of 2020 had already started to slow.
We all know what happened next. With massive amounts of stimulus, world central banks prevented a steep recession. In essence, they shortened fall and winter (recession) to just eight weeks (the shortest recession on record). Then spring was bypassed altogether, and summer was back for another round of growing season, sunshine, and picnics.
Fast forward to today and it is literally and figuratively getting cooler this October. Instead of prolonging summer, the Fed is trying to orchestrate an economic transition into fall – ideally with little to no subsequent hint of winter. This is indeed difficult and the Fed’s track record of successfully pulling off what is referred to as a “soft landing” is spotty at best.
As I’ve said before in these pieces, seasons are essential for the long-term healthy functioning of our economic system. A summer season that lasts too long can create droughts, soil depletion, and other unintended consequences. In the markets, it creates excesses in the form of valuations that get too high and encourages risky behavior like leveraging bonds and stocks to amplify returns.
Fall and winter seasons are needed. Fall’s dead leaves decompose in the soil, allowing for a healthier, more sustainable spring and summer. Winter snows fill reservoirs which in turn nurture summer crops.
We look forward to returning to a more normal economic expansion – one in which stocks are valued on their economic merit and one where savers can get real (above inflation) yields on their fixed income investments.
In that vein, we know that despite the inevitable changes in market seasons, history tells us that market summers last much longer than winters. It is also exceedingly difficult to try to time the shift. As soon as it’s apparent that an investor should take out their parka, the market will have already moved onto swimsuit season! This is because stocks trade on a forward-looking basis. The market will start higher well before the bulbs break through the soil.
This is precisely why BSW makes moves at the margin, remains invested in stocks and rebalances into the changing environments. While investors argue over how potentially cold it could be this winter, BSW is cultivating the soil and preparing for spring.
Thanks for Reading!
This blog is created and authored by BSW Wealth Partners, Inc., a Public Benefit Corporation (“BSW”) and is published and provided for informational purposes only. The opinions expressed in the blog are our opinions and should not be regarded as a description of services provided by BSW or considered investment, legal or accounting advice. Certain information sited is from third-party sources and while we believe the information to be accurate and true to the best of our knowledge, we cannot guarantee its accuracy as there may be certain unknown omissions, errors or mistakes. Use of third-party information, including links, is in no way an endorsement by BSW. The views reflected in the blog are subject to change at any time without notice.
Nothing on this blog constitutes investment advice, performance data or any recommendation that any security, portfolio of securities, investment product or investment strategy is suitable for any specific person. Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by BSW), or any non-investment related content, made reference to directly or indirectly in this blog post will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Not all BSW clients will have the same experience within their portfolio(s) and certain topics discussed in this blog may not apply to all clients or investors. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from BSW. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. BSW is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of BSW’s current written disclosure statement discussing our advisory services and fees is available upon request.