Markets slide as Fed steps up its inflation fight

Sticky inflation, recalibrating expectations

After regaining significant ground since the June lows, equity markets have once again reversed course and are retesting those summer levels. The primary storyline underlying the recent retracement remains unchanged: higher than expected inflation, a persistently hawkish Fed, and renewed fears of a hard economic landing.

Despite headline inflation falling modestly in August, core CPI (which excludes food and energy) accelerated to 0.6%, lifting the one-year rate to 6.3%. Headline CPI might dominate the news cycle, but the importance of core inflation shouldn’t be underestimated. The surprise upside renewed concerns that stickier core price increases may be more persistent than expected (or at least hoped). It was also a critical data point leading up to the September FOMC meeting, and one that erased any doubts about the probability that policymakers would err to the side of doing more than doing less.

Headline CPI might dominate the news cycle, but the importance of core inflation shouldn’t be underestimated.

With the Fed becoming more vocally firm in its commitment and aggressive in its tactics to curtailing inflation, policymakers delivered their third consecutive 0.75% increase last week to lift the Fed funds target range to a range of 3.0 to 3.25%. The Fed also made some meaningful adjustments to its economic projections for the next few years, raising its inflation forecast and lifting its likely policy interest rate path in response. The Fed also now projects the Fed funds rate to end 2022 at around 4.4%, consistent with an additional 1.25% in rate hikes over the next two meetings in November and December.

The result? A likely increase in unemployment over the course of 2023 and slower growth. The Fed’s forecast for real GDP growth was lowered to reflect projected growth of just 0.2% in 2022 — a marked reduction from the June projection of 1.7%. The underlying message was seemingly clear, signaling the central bank’s commitment to doing whatever would be needed to bring inflation back to its 2% target, even at the expense of further near-term deterioration in growth and potential job losses.

Since the CPI release on September 13, the S&P 500 index has fallen by more than 10% (fully retracing its late-summer rally) and has returned to bear market territory, down over 20% since the beginning of the year. Small-cap and international stocks have experienced similar declines. Short-term bond yields continue their sharp move higher, with upside also extending to long-term rates. The yield on the 10-year treasury note now tops 3.7% — a level not seen in over a decade.

Soft landing or recession?

It’s no secret that the economy has slowed considerably this year, largely in response to the massive shift from the hyper-stimulative pandemic-era policy to simultaneous fiscal and monetary tightening. The boom in spending that resulted from massive stimulus and ultra-accommodative financial conditions has since rolled over as policymakers attempted to do enough to slow growth and tame inflation without going too far.

Successfully engineering a tightening cycle that results in a “soft landing” is a difficult task in the best of circumstances. The complexity of today’s environment makes it arguably more difficult than in some other cycles. As Fed Chair Jerome Powell noted in his July press conference, “these are not normal times.” Beyond domestic considerations, a return to a more normal global economic environment has proven to be more elusive than policymakers had anticipated. Clearly, the challenges aren’t contained to the United States. China’s so-called “Zero Covid” policy is still curtailing the supply of many goods exported to the United States and elsewhere. The deepening war in Ukraine remains a human tragedy first and foremost but has also created long economic shadows globally, notably impacting the flow of oil, gas, grains, and other agricultural and industrial commodities to Europe, the Middle East, North Africa, and beyond.

Successfully engineering a tightening cycle that results in a “soft landing” is a difficult task in the best of circumstances.

Consequently, the global economy continues to slow, exacerbated by supply-side factors that are well outside the Fed’s ability to influence. (Higher interest rates and the withdrawal of liquidity by the Fed is largely focused on cooling demand; it can’t fix supply-side challenges.) Despite talk of recession over the past several months, a significant amount of economic data appears to point to moderate growth, while confirming a marked slowdown in the pace of growth since last year. It’s clear that the Fed’s path to a soft landing has narrowed, as illustrated by even the Fed’s projections that forecast an increase in unemployment next year that would align with a mild contraction. The convergence of risks — from the inflation generated in part by an economy running too hot to the potential for aggressive Fed tightening pushing the economy into recession — that has been the catalyst for renewed market volatility. Understandably, investors are frustrated, as is typically the case when market volatility flares and uncertainties are abundant.

Navigating uncertainty

Amid the fog of uncertainty that blurs the economic landscape today, market volatility may persist for some time. From inflation, monetary policy, corporate earnings, and ongoing geopolitical risks to the upcoming midterm elections — there’s no shortage of factors investors will weigh as they digest incoming data and its implications for the macro environment. At the same time, we know that equity markets have historically tended to perform well after inflationary periods when the pace of price increases rolls over, well before they return to more palatable levels. U.S. equities tend to be volatile leading up to midterm elections, but often rally in their aftermath. In either example, the improvement in market conditions doesn’t happen because all risks or sources of uncertainty have been definitively resolved. The markets typically sniff out better days ahead before they actually arrive.

During these periods of uncertainty, investors should keep the following considerations in mind:

• The market is not the economy. The forward-looking nature of equity markets means stocks will price in expectations for the economy before they become reality, generally three to 12 months in advance. Given the market environment over the last nine months, a significant degree of bad news has already been priced into markets. Any signs of an easing in the various risks weighing on investor sentiment could be a positive catalyst for equity markets.

• Just like bull markets, bear markets are a normal part of a cycle. While challenging to live through, we know that bear markets are inevitable, and a typical investor will have to endure a considerable number throughout their lifetime. If there’s good news, it’s that those negative periods tend to be comparatively brief. Since World War II, the average bear market has lasted about a year, while the average bull market has been considerably longer, extending over more than six years.

• Timing the market is futile. Psychologically, it’s tempting to want to “do something” to avoid further downside, but a vast amount of industry research has shown that investors often make decisions at the wrong time. It’s important to not abandon one’s investment strategy by going to the sidelines in anticipation of a better market environment in the future. Because market recoveries tend to begin when sentiment is still very low, waiting for brighter days almost always results in missing out on some of the strongest market returns in a given cycle. Staying invested ensures that an investor participates in the recovery that inevitably follows the market downturn that they’ve already lived through.

• Volatility creates opportunity. Lower prices and more attractive valuations create the potential for stronger future returns across asset classes and multiyear time frames. Rebalancing, tax-loss harvesting, and taking advantage of market opportunities that emerge in the aftermath of market turmoil are active ways to benefit from these periods. 

• Time horizon is critical. While no one can accurately predict the near-term direction of the markets with certainty, it’s important to remember that each bear market of the last century was followed by a recovery, each time pushing to new highs. Over time, the probability of equities rising on any given day is slightly better than 50%. But since 1936, the S&P 500 has provided a positive return over a 12-month period over 75% of the time; over five years, that probability rises to over 90%.

Ultimately, investors who focus on the things they can control, while tuning out the daily noise, are better equipped to navigate difficult market environments. Having a well-conceived investment plan, staying broadly diversified, maintaining adequate cash reserves, focusing on the long term, and remaining disciplined have proven to be successful elements of a strategy to reach one’s investment goals and objectives over time. We’ll continue to carefully monitor global financial markets for developments and potential opportunities provided by the macro environment and will recommend changes as appropriate to adjust portfolio positioning within the context of your plan.

And to our clients, we thank you for the opportunity to serve you and encourage you to reach out to your PMFA advisors with any questions or concerns.