Thanksgiving is rapidly approaching, and I find it unfathomable that Christmas is only six weeks away. As Geoffrey Chaucer said, “Time and tide wait for no man.” With the world continuing to speed along, I hope and pray we all have time to pause and reflect on the many blessings in our lives. I certainly count you among ours, and we are so grateful for your friendship and your business.
These uncertain economic conditions provide me further motivation to pause and reflect on all we have to be grateful for. This summer, I wrote of the economic cross currents and confusion that reigns supreme. Since then, we have had even more questions and very few answers. When will inflation peak? How long will the Federal Reserve (Fed) increase interest rates? Will our economy enter a recession? After three months of discussion and debate, our vision and path forward is somewhat more defined, but we still have no clear answer.
The recent election results remain an additional question, though gridlock appears likely. Gridlock has been good for stock market investors in the past few decades, particularly when there’s been a Democratic president with the Republicans in control of at least one house of Congress. However, there are some material differences between the current economic situation and the two most recent instances of gridlock. In November 1994, consumer price inflation was running at 2.7%; in November 2010, the CPI was running at 1.1%. Right now, inflation is running north of 8.0%, and the Federal Reserve is ratcheting up interest rates no matter who wins.
Back in the 1990s, theoretical “gridlock” ended up being a mirage, as President Clinton and congressional Republicans collaborated on a myriad of issues including welfare reform, trimming Medicare, cutting the capital gains tax, and expanding free trade. President Obama and congressional Republicans agreed on much less, but “gridlock” meant no more expansion of entitlements, such as health care, and did result in a compromise that extended much of the Bush tax cuts originally enacted in 2001 through 2003.
While investors should not ignore election results, and election results might significantly influence which market sectors outperform over the next several years, economic fundamentals ultimately dictate equity market performance. Higher interest rates have been a key component to the headwinds for stocks this year; next year it’s likely to be weaker profits as the “sugar high” of stimulus fades and interest rates inhibit growth.
Recent data may be pointing to a slow down or potential peak in inflation. While this is certainly welcome news, I continue to believe that headline inflation is unlikely to meaningfully fall in the next several months. The reality is that inflation has been higher than even I anticipated and is lasting longer than most have feared, which underscores the lingering impacts from printing $5.4 trillion. I continue to believe that most inflation is a monetary phenomenon, and it would be more effective to manage the growth in money supply and the Fed balance sheet for consistent inflation control. Hiking short-term rates has deleterious effects on the economy. I find it ironic to reflect on the adjectives Federal Reserve Chairman Jerome Powell has used this year to describe the state of inflation which have ranged from ‘transitory’ to ‘persistent’ to ‘peak.’ Let’s call it what it is – PAINFUL!
An additional pain point this year has been the material underperformance of growth stocks in general, and specifically the technology and communication sectors. I have written about and continue to emphasize the need for a ‘different playbook’ because of these structural changes in the economy, and investors who believe these areas could potentially return to their prior luster will be disappointed.
It’s wasn’t long ago when “FAANG” (Meta, Apple, Amazon, Netflix, and Alphabet) seemingly could not lose, and yet through the end of October, the information technology and communications services are down 27% and 39% for 2022 respectively. Historical perspective is beneficial when you consider the last twenty years. Flash back to October 2002: Apple’s iPod is a year old, and Microsoft and IBM are the only tech companies in the world’s largest 10. In fact, the technology and communications sectors comprise only 17% of the S&P 500.
Since then, Mark Zuckerberg launched Facebook from his dorm in 2003, Netflix began streaming in 2007, and Apple became the first $1 trillion company in 2018 and subsequently passed $2 trillion in market capitalization in 2020. Today, technology and communications make up 32% of the S&P 500 and have become a main driver of overall market performance.
While the party may be over, for now, technology and communications businesses are not going anywhere. Longer term, there are several tailwinds that should be supportive, and I am excited to see where innovation takes us in the next twenty years. However, I am less than enthusiastic over the sector’s performance in the more immediate term.
This summer, with economic conditions in a state of confusion, I believe the weight of the evidence did not suggest an imminent recession. Currently, we are facing slow growth, weakness in China and Europe, and continued war in Ukraine. None of which would be considered positives in any aspect. The largest hurdle the economy continues to face is the Federal Reserve and their increasingly aggressive policy stance, of which Chairman Powell has advocated since late August. If the Federal Reserve continues on its current defined course, it will be the most aggressive policy stance since the early 1980s, and further pain is ahead for both individuals and businesses.
With the Federal Reserve propelling rates higher for a more protracted period of time, I now believe a recession is quite likely, and the Fed’s ability to juggle an economic soft-landing relative to a hard one is compromised. The distortions of economic activity from lockdowns, massive deficit spending, and money printing are immense.
How does all of this frame investment decisions for investors? In my opinion, we are likely in a range bound stock market. The bottom of the range is likely reflected in the lows seen in June and again in September, where the plethora of bad news has led equity prices to a level that likely already discounts a shallow to mild recession. The top of the range I expect to be below the former highs. I do not believe the equity markets will exceed the former highs until long-term interest rates stabilize and the Federal Reserve stops hiking short-term rates higher.
Markets such as these reinforce the purpose and foundation behind crafting a solid financial plan and creating moats of defense around our clients. My mantra in this environment remains “Get paid while you wait,” and we have been helping clients focus their portfolios on doing just that.
On a positive note, the silver lining to these capital markets has been the incredible increase in bond yields. After seeing lows in ten-year treasury yields of 0.50% in 2020, they have recently yielded more than 4.3%. Bonds are buyable again; we can finally see the value of adding more bonds back into investors’ portfolios and would continue to opportunistically add fixed income to balanced portfolios.
Thank you for your continued trust and confidence as we navigate these uncertain times. Please feel free to call or e-mail with any questions or concerns, or if there is anything we can assist you with.
Best personal regards,
Erik Melville, CFP®
Senior Vice President/Investments
(772) 672-5125 | [email protected]
Past performance is not indicative of future results.
The Standard & Poor’s 500 Index is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.