After the worst first half for stocks since 1970, markets enjoyed a brief summer respite as participants began hoping for a Fed pivot. We have previously communicated our concern that hope for a more dovish Fed was premature. This hope-based rally gave way to the worst September in 20 years and the third quarter ended down ~5%, marking the second straight quarter the S&P ended in bear market territory. As of this writing, the S&P is down 21% year-to-date.
The first two quarters were especially confusing from an economic perspective. Back-to-back quarters of negative GDP growth is the generally accepted guideline for a recession. However, the economy was also adding jobs along the way, which makes it hard to square with a recession. The actual yet foggy definition of a recession is: “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” Given weak economic activity, one could be forgiven for wondering why the Fed continues to be so aggressive. During the last serious battle with inflation in the 1970s, the Fed charted a “stop & go” approach which forced the Fed to resume the fight against inflation three separate times during the decade. This prolonged the process, as well as the economic pain. This Fed does not want to make the same mistake.
There are silver linings that come with every downturn. Our investment philosophy has always leaned on “balanced” accounts. Typical accounts generally have 30-40% of their investments in bonds. While bonds tend to return less over time than stocks, they provide income, stability, and the ability to periodically reinvest money in a future, unknown investment landscape. After the GFC (Great Financial Crisis) rates were cut to zero and bond yields were so meager as to be almost non-existent. The renewed ability to earn 4% in short maturity bonds is an arrow we are very thankful to have back in our quiver. There is a strong possibility that fixed income will become increasingly important to total returns for some time.
The Fed’s tools are blunt instruments and take time to work their way into the economy. We can’t help but think the slowing from higher rates has yet to be meaningfully reflected in the economic data. As such, we will not be surprised if the expected economic slowdown from higher rates may not fully present itself for several more quarters. Historically, the Fed continues hiking until something breaks. We haven’t seen the type of capitulation that comes with panic selling. Insider buying has been relatively absent. Overall valuations are less expensive, but not yet cheap. And, up until now, nothing has broken. Markets will likely bottom before economic activity does, but we doubt the anemic economic activity of the first two quarters will end up being the end of the economic pain in this cycle.
We count ourselves blessed as advisors, in no small part because we have many multigenerational relationships going back as far as the 1960s. We have worked alongside many of our clients through multiple bear markets, which makes each subsequent one that much easier to endure together. We are busy rebuilding short-term, high quality bond ladders. We are also reviewing opportunities to reset cost basis in high conviction names and manage capital gains. There are opportunities in any market, but we continue to exercise patience as the world continues adjusting to the largest change in interest rates in a half century.