With Gross Domestic Product (GDP) contracting for a second consecutive quarter in Q222, the U.S. economy has technically entered a recession, although many political figures would have us believe otherwise. If we’re not in “recession” already, we (likely) soon will be – financial markets have essentially told us so. Financial markets are almost always ahead of reality, in terms of discounting future earnings, directional moves in interest rates and even seasonal fluctuations in supply and demand. The last 6-12 months have been no exception, with nearly all parts of the market having sold off considerably. Domestic and international stocks are down 19-33%, bonds are down almost 17% and, more recently, even commodities are off approximately 20% from their highs. With respect to the equity market at least, drawdowns of 20% or more like this usually presage recession.
Lately, the market has been adjusting to many things: the Fed’s campaign to head off rampant inflation (by raising interest rates), even as global growth continues to slow; the war in Ukraine, which has significantly boosted food and energy prices; and a widespread lockdown/shutdown in China, as that country pursues a no-tolerance policy in response to a serious re-emergence of COVID. All of these events are bad for investors and the financial markets have generally discounted valuations ahead of most adverse occurrence and consequence. As an investor, the adjustments haven’t been enjoyable, and things may get worse before they get better, but there may be some light at the end of the tunnel – at least in 2023.
In the stock market, emerging and developed international indices were the first to peak and begin their descent: the former, as measured by the Vanguard Emerging Markets Stock Index, peaked in February of 2021 and fell by nearly 29% by mid-July of 2022; the latter, as measured by the iShares MSCI EAFE ETF, peaked in September of 2021 and fell by nearly 27% by mid-July of 2022.
International pullbacks were largely due to rising inflation expectations in Europe and the anticipation of war in Ukraine, as the Russians began massing significant troops on the Ukrainian border in November of 2021. Drawdowns were further exacerbated by a serious outbreak of COVID in China this past March, which resulted in swift lockdowns, travel restrictions and widespread testing, further contributing to global market unease and capitulation. In both instances, sell-offs (or the continuation thereof) tended to take place well in advance of the adverse events themselves.
In the U.S., small-cap and Nasdaq stocks peaked in November of 2021, while Dow Jones Industrial and S&P 500 stocks peaked in January of 2022, right around the time the Fed started talking about raising interest rates – the Federal Reserve Bank didn’t actually begin raising interest rates until March of 2022. Since that time and through mid-June of 2022, the Russell 2000 Index fell over 32%, while the Nasdaq, Dow and S&P 500 indices all fell approximately 34%, 19%, and 24%, respectively.
Domestically and in addition to the influence of international events, investors have clearly been concerned about an increasingly aggressive Federal Reserve Bank, and a series of interest rate increases intended to dampen inflation. In June of 2022, the trailing 12-month inflation rate was 9.1%, as measured by the Consumer Price Index (CPI), and the Fed is determined to bring price increases under control by raising rates and slowing down the economy in the process. Investors’ main concern seems to be the Fed’s propensity to overshoot its mark, raising rates too far, too fast, and ultimately pushing us into “recession” – the market seems to have already discounted this possibility.
In the fixed income (bond) market and as previously mentioned, the Fed didn’t begin talking about raising interest rates until late 2021 and didn’t begin raising interest rates until March of 2022. Here again, however, investors were ahead of reality, broadly selling bonds beginning in July of 2020 in anticipation of future rate hikes. When rates go up, bond prices come down. Investors, therefore, began selling their bonds in advance of Federal Reserve action, hoping to avoid losses that would have otherwise resulted.
Interestingly, the iShares Core Aggregate Bond ETF peaked in price at the end of July 2020, implying that rates had bottomed, and that the worst of the COVID pandemic was over. Since then, the index has fallen nearly 17% through mid-June of 2022, in anticipation of actual Fed rate hikes. Viewed another way, the 10-year Treasury bond yield bottomed at approx. 0.5% in August of 2020, implying that price had peaked. The 10-year Treasury yield has since increased to approximately 3% as of 7/19/22. Essentially, the Treasury market has already discounted (i.e. sold off in anticipation of) two and a half percentage points of rate increases (off a bottom of 0.5%), even though the Fed has only raised rates by 2.25% to date. Has the sell-off in the bond market been overdone? That remains to be seen.
The Fed intends to raise the Fed Funds rate another 1.00% to 1.25% by the end of this year. If the Fed proceeds as planned, therefore, bond prices may have further to fall (i.e. the bond market has only discounted additional rate increases of approximately 0.25%, while they may end up being 1.25% or even more). Similarly, inflation has yet to peak and, from a purely technical perspective, the Dow Jones Industrial average may have another 10% or so to fall, to reach established support levels if the Fed does, in fact, push us into “recession” – vulnerable, let’s say, to 28,000 or 29,000. On both sides of the market, additional downside risk exists.
The Fed Funds rate is projected to increase to approximately 3.8% in 2023 and then fall to approximately 3.4% in 2024 – and this is where investors may find a silver lining. Rate cuts beginning in 2024 imply that the Fed will have pushed us into “recession” by then (if we’re not already in one) which, in turn, will cause them to reverse course and begin lowering rates accordingly. It also means that equity and fixed income markets ought to begin discounting that occurrence well ahead of reality, resulting in a financial market recovery sometime in 2023.
The main takeaway here is that financial markets seem to have discounted most, but perhaps not all, of the bad news yet to come. The good news is, that since financial markets are almost always ahead of reality, bluer skies for investors may not be far away.
Rossi is senior vice president and senior equity strategist at Canandaigua National Bank & Trust Co.l