Friday Reflection | May 20, 2022
This week saw US and international stock markets continue to decline, marking the seventh consecutive week of the current trend. The S&P 500 index temporarily dipped into official bear market territory during trading today, which is defined as a decline of at least -20% from a recent high. Paired with the noise of inflation fears, continued conflict in Ukraine, and alarmist financial media, it’s easy to have the sense that everything is unraveling. In reality, the current stock volatility is part of a normalization process for the economy and interest rates – and this week we saw signs that patterns are shifting and the normalization process is gaining traction.
Normalization includes moving away from excessively low-interest rates, and all the economic and market adjustments that come with that. The Fed is moving quickly right now to push those processes along, creating a more intensive – and disruptive – period of adjustment. A first sign of progress came as the bond market continued to move higher this week, marking a shift to a normalized relationship with stocks, in which bonds balance portfolio performance during periods of stock price decline. Supply chains are being re-routed and shifted, and valuations based on extraordinary growth in the tech sector are being recalibrated for the new landscape of higher interest rates.
Still, we expect continued volatility in the near term. The process of rightsizing the economy and investor expectations after a decade of zero percent interest rates won’t happen overnight. Low-interest rates impacted all aspects of our economy and influenced consumer behavior. The adjustment period will be bumpy, but it will also set the stage for the next phase of economic growth.
Adjustment Takes Time
Both Target and Walmart announced disappointing earnings this week and reported that they are seeing some drop in demand, and a shift from discretionary purchases to staples. While inflation today is largely a result of supply shortages, a reduction in demand can help get inflation under control. Paradoxically, current reports of lower demand for goods are thus a positive sign for long-term economic health and lower inflation.
While demand for certain goods is declining, demand for travel is looking strong despite high prices. Airbnb reported that the company booked more than 102 million lodging and travel “experiences” in the first three months of this year, setting a new quarterly record, and indicated strong trends through the summer. The impact of summer travel should provide a boost to economic data in the coming months, though it won’t be reflected in corporate earnings until late fall. Regardless, it’s an encouraging sign and a data point economists have been tracking throughout the COVID recovery period.
Positive signs aren’t yet visible in some sectors. High gasoline and household energy prices could get worse as Russia’s war in Ukraine drags on and more nations stop buying Russian oil. Service-sector inflation could also heat up as spending patterns shift toward services and away from physical goods, though this may provide some additional relief to stressed supply chains for goods as part of a broader normalization of spending patterns.
Bonds Lead the Way
Broadly speaking, inflation impacts corporate profits as much as consumer spending decisions. Despite seeing a small gain in the April retail sales report, and despite retailers raising prices, profit margins are shrinking. Target and Walmart have been joined by other companies who may hit their revenue target but disappoint investors with lower earnings. Investors are marking those stocks down to mid-2020 levels. Companies whose stock prices rose wildly because of the pandemic, such as Netflix and Peloton, as well as consumer companies, need to recalibrate in a moment of economic pause. Overall, the economy shrank in Q1 by -1.4%, and despite strength in areas such as travel and energy, the view of the path ahead for stock prices is muddled.
We wrote recently about how bonds had ‘misbehaved’ so far this year, experiencing difficult but logical declines in the face of rising interest rates, but not playing their traditional role as a stabilizing force in a balanced portfolio. Over the past month, that traditional relationship has begun to re-emerge: the broad US bond index has been stable and has grown slightly while the broad stock indices have slid by approximately -10%. Stability in the bond market is one of the first hurdles for stabilization in the broader financial markets. Economist Dave Rosenberg said this week, “before you become bullish on equities, you first must become bullish on bonds.” The bond market began to decline in advance of the stock market as the Fed raised interest rates, and we are not surprised to see it begin to recover in advance as well.
Extreme changes in economic activity and securities prices sow the seeds of their own re-adjustment, and this moment is no different. Analysts believe some of the factors that led to retailers missing earnings this week — such as stockpiling more inventory than they could sell — could ultimately be a silver lining. Higher inventories will have a deflationary impact down the line, and potentially afford the Fed flexibility to take their foot off the gas and provide relief to financial markets and consumers.
Investing in People, Companies, and Ideas
Since the beginning of the year, securities markets have largely traded based on fear of inflation and higher interest rates, and their impact on global economies and businesses. Daily news cycles compound the fears, and the financial media duly prints charts of prior crashes, drawing loose comparisons and casually implying predictions of more pain.
While we can’t predict how long stock price declines will last, we are committed to calmly maintaining stock exposure and regular rebalancing. This isn’t based on a rosy outlook for the near term but rather is based on an understanding of history and past market corrections. Investing is itself an exercise in optimism for the future, and historically has paid off – for patient investors. We remember the amazing capacity for ingenuity, novel partnerships, flexibility, and innovation that got us through the initial phases of the pandemic and helped us overcome various challenges throughout history. Although the generic terms “stocks” and “bonds” can obscure it at times, the reality is that our portfolios are invested in real companies, people, and ideas, and those are investments that we continue to have tremendous confidence in.
Many level-headed individuals and institutional investors – including many of our clients, our investment committee, and the fund managers we work with – are keeping calm, examining portfolios for areas of potential continued weakness as well as energetically looking for opportunities created by irrational prices. This many-minded blend of actions creates a picture that looks chaotic in the short term. It is a cacophony, but also a sort of symphony, as a broad range of investor decisions come together to create a path towards normalization.
About Brian Kozel, CFP®
Brian Kozel is a Partner at North Berkeley Wealth Management. Brian helps clients feel confident as they navigate their financial journey.
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