While some of the following will be in my quarterly update, I want to go ahead and share some of our thoughts about this challenging market for both fixed income and equity investments so far this year. There seems to be an almost constant recitation of how bad things are, and I want to cut through the headlines to share some positive items and trends that we see, and observations from which we are working.
We are all aware of the current inflation situation. There are 2 basic ways to address this issue. The first is by increasing supply, and the second is by decreasing demand. Given supply chain constraints that have continued into 2022, it has been difficult to increase supply to the levels necessary to fulfill demand. This leaves the Federal Reserve, whose main goal is to maintain stable prices, to tackle inflation from the demand side. The two methods it is currently using to reduce demand are raising short-term interest rates, and unwinding its $9 trillion balance sheet. Both items will work to weaken demand.
In the past, the Fed has been very sensitive toward not upsetting the stock market too much. However, with inflation at these levels it has little leeway to think about the stock market. The equity markets are rightfully nervous that the Fed will overuse its strategies and create a worse-than-expected economic slowdown. This is one of the main reasons for the equity market sell-off. Add to this that we are experiencing the worst bond market in 40 years, and you get a short-term recipe for both uncertainty and volatility.
While we’ve become accustomed to quick “V-shaped” market recoveries, like which we experienced in the aftermath of the pandemic in 2020, and others these past twelve or so years, they are not always the case. In fact, it is more typical that we experience a “U-shaped” market recovery which happens when the market bounces along the bottom for a few quarters.
Where does that leave us?
Good News Item #1: The macroeconomy, while slowing, is still doing okay. If we have a recession, we do not expect it to be deep or long. In addition, we expect the market to rise before the National Bureau of Economic Research calls the economic bottom. We believe we are closer to that now than the beginning of this cycle.
Good News Item #2: We believe we are experiencing peak inflation now, and expect to see it decline (albeit at a slow pace) over the second half of the year. This will be a welcome sign to the equity and bond markets.
Good News Item #3: The labor markets are very strong, and the Fed’s actions should not lead to a high unemployment situation.
Good News Item #4: While it may slow a little, retail sales remain strong despite shifts between goods and services, and wants and needs.
Observation #1: The markets are waiting for news of lower inflation. It may take us a few months to get to this point, during which time we will continue to experience volatility, and perhaps even retest market lows. Retesting lows should not be viewed as a bad thing. Historically, the market will retest the bottom multiple times before making a sustained turn higher.
Observation #2: We made changes to the model portfolios this year on both the equity and fixed-income side, which have helped mitigate some of the downside this year. We will continue to tweak our models based on how the second half of the year unfolds.
Observation #3: We have started seeing green shoots appear from Leading Indicators that we track. We expect these shoots to continue to grow, and we need a few more months of data to confirm our view of the timing of the next economic upswing. Currently, the bottom of this economic cycle appears to be in the 1st, or beginning of the 2nd quarter next year, and we would expect equity markets to turn up some 6 months prior to that. This is not a promise, but an expectation that we will continue to watch closely.
Harvest Promise: We will be here to walk through this together. Our door is always open if you want to come in and talk. Alternately, feel free to call if you want to discuss the economy or your concerns. I have every confidence of this market and economy recovering, and I am satisfied with the changes we have made to weather this challenging time. We thank you for your confidence in us, and please feel free to reach out as we continue to communicate with you. Thank you.Marc Henn, CFP