Equity and bond markets rallied in July to start the third quarter, but both sold off sharply again in August and September to establish new lows for the year. The rally in July was a result of investors optimism over the possibility of a soft landing for the economy. However, the Federal Reserve (Fed) and other central banks reiterated at their Jackson Hole summit in August that their priority remains the fight against inflation rather than supporting the economy and growth. This was the catalyst for a significant sell-off in bonds and stocks in the second half of the quarter. Central banks backed up the rhetoric with rate hikes totaling 1.50% from the Fed, and 1.25% from the European Central Bank. Markets reacted by pricing in a much more aggressive path of future rate hikes, with rates now expected to rise to more than 4.60% in the U.S. These rates influence consumer borrowing costs significantly, as evidenced by 30-year mortgage rates rising to above 6%, their highest level since 2007.
Regarding inflation, consumer prices were flat in July and rose just 0.1% in August, with the year- over-year inflation rate falling to 8.2%. Despite signs of moderation, markets reacted badly to August’s consumer price index (CPI) data where a 10.5% decline in gas prices offset significant increases in other areas of the economy such as shelter costs, which rose by 0.7%. Overall, core inflation is expected to trend lower in the coming months, but will remain above the Fed’s target for some time.
Simultaneously, employment data is coming in very strong with an exceptionally low unemployment rate of 3.5% in the U.S. The tight labor market is creating substantial household income gains with a 5.2% increase in average hourly earnings and a 4.1% rise in payroll jobs. The problem is that good economic data supports strong corporate earnings and stock prices, but provides cover for the Fed to continue hiking rates. On the other hand, bad economic data means the Fed may stop sooner but corporate earnings will suffer. This is the market’s conundrum right now.
With the S&P 500 now down 25% year to date, much of the economic pessimism has been priced in. Global equity market valuations have now generally fallen below their 25-year averages. In the U.S., the market is currently trading on a price-to-earnings (P/E) ratio of 15.6 vs. a long- term average of 16.6. In other developed markets, the valuations are even more compelling and have historically been good entry points for long term investors. However, these valuations are based on current consensus analyst forecasts for earnings growth, which are gradually being revised down due to the risk of a more severe recession. Therefore, we could still potentially see further declines in equities.
Going forward, the global economy will likely continue to slow, with some economies entering full blown recession. Central banks are facing the biggest inflation shock since the 1970s and will likely continue to prioritize the fight against inflation over supporting growth. Therefore, we expect more choppy markets as investors weigh how far rates will need to rise to combat inflation and how much damage will result in the process.
At the portfolio level, we made a tactical shift in May towards growth stocks as it appeared the Fed might not go too high with rates. That helped capture more of the July rally than our base strategic model. However, the Jackson Hole communication confirmed that would not be the case, and we quickly shifted back to a more defensive, value stance. This is the benefit of having a professional advisor adapting to what the economy presents. For now, we remain invested, but with a defensive, value-based approach that will at least capture solid dividend returns while we wait for more clear direction on the economy and markets.
Please know that we realize how difficult this year has been. All our principals are invested right alongside you in the same portfolios and have felt the same pain. We have been through bull and bear markets before and understand this is a long-term process. We know that with markets down 25%, the following three to five years typically present exceptional returns. We also know that markets are forward looking and by the time we have reached the economic bottom, markets will have already started the recovery process. Patience is the key.
As always, we appreciate your trust as a client and are available at any time to discuss your specific portfolio and financial circumstances. Please reach out to our Wealth Advisor, Banner Clark, at bclark@sagacewealth.com if you have any questions.