Thoughts on the Current Environment
A year ago, stocks were riding all-time highs, primarily driven by a handful of large, U.S.-based technology companies like Netflix, Facebook/Meta, and Amazon. Interest rates were low, inflationary pressures were manageable and thought to be transitory, and the forecast was for continued strong economic growth. Fast forward to now and there’s a war in Europe, most equity markets are solidly in bear market territory (i.e., down more than 20% from their previous highs), inflation is at its highest level in 40 years, and talk of an impending recession is increasing. With this in mind, we share some of our thoughts on investing in the current environment:
Why is there inflation?
A key reason is an increase in labor costs. Some of the contributing factors to this increase have been pandemic related, such as changing worker attitudes and an increase in demand for services as consumers venture out ready to spend money they had saved up by staying home. Other factors have been longer-term, such as importing deflationary pressure from China – inexpensive Chinese labor has driven down the cost of U.S. labor for decades, and now the U.S. labor force is catching up. In fact, some of what are commonly referred to as supply chain constraints are really labor constraints. For example, fewer people are willing to drive trucks for low wages (increasing shipping costs) and airlines are at capacity because of previous downsizing. Couple labor constraints with high consumer demand, and prices have risen.
A secondary reason has been Russia’s war in Ukraine, which has sparked constraints in the supply of oil, gas, and grain.
What has caused the bear market? Are we heading into a recession?
Through much of the first half of 2022, corporate earnings have been strong, unemployment has been low, and consumer demand has been high; however, persistent inflation is driving the Fed to raise interest rates, driving the decline in stock prices (particularly in the first quarter). Growth stocks took a direct hit as a rising interest rates cause the cost of debt to increase and make future earnings (which growth stocks promise) less attractive to investors. Instead, value stocks have been back in favor, offering earnings in the here and now. According to Bank of America, the outperformance of value stocks relative to growth stocks is the largest since the burst of the dot-com bubble 20 years ago.
In the second quarter, investor fears of an economic slowdown impacted stock prices, with the Fed set to continue aggressive rate hikes. One indicator that a recession may be on the horizon is an inverted yield curve, which has preceded every U.S. recession since 1956. Normally, investors expect a higher yield for longer-term bonds as compensation for illiquidity and to counter the effect of inflation during the time to a bond’s maturity. When investor demand for longer-term bonds causes yields to drop below those of shorter-term bonds, it signals that investors are willing to be paid less in exchange for the relative safety that longer-term Treasury bonds offer. As of July 20, the yield on two-year Treasury notes was 3.23% while the yield on 10-year notes was 3.03% (see Figure 1). According to an analysis from Deutsche Bank, the average time to a recession after two-year yields rise above 10-year yields is 19 months, with the shortest time being six months and the longest being four years.
Should we exit the market and move to cash to avoid further losses?
Institutions and multi-generational families are long-term investors, and global recessions tend to be short-lived. Getting out of the market to avoid a potential downturn puts a long-term investor at risk as it is very easy to miss the snap-back in stock prices. Markets tend to anticipate economic changes and stocks typically bounce back long before it becomes apparent that a recession has bottomed. It’s important to stay invested.
We welcome your questions and conversation.
The Mangham Associates Team