Economic Monitor: The Times They Are A-Changin'

BY: Mark Drachenberg


In the financial world as everywhere, change is inevitable. It happens both in the blink of an eye and slowly, over time, for reasons obvious and subtle. Recently, investors have seen change spurred on by government policies, corporate profits, economic factors, and geopolitical events. The Fed is switching from its easy-money policy to one of tightening; investors fear higher rates, inflation, and elevated valuations; and Russia’s invasion of Ukraine has the world on edge. Echoing the title of the Bob Dylan classic, the times they are a-changin’.

While the Fed’s typical response to inflation is to tighten and raise rates, economic data is in a constant state of flux, and geopolitical events (including wars) causing upheaval are the norm and not the exception, the confluence of these things happening at the same time is somewhat rare, and therefore makes our current situation more problematic. It has the makings of a perfect storm, though whether one materializes remains to be seen. Regardless, it's important to remember that these things, too, shall pass.

Financial Markets

It appeared things might settle down as we moved into February, but change did not come, and the markets continued to fall. The threat of rising and sustained inflation pushed the markets lower, and then the reality of the Russian invasion of Ukraine added to the damage. Even a relatively strong earnings season couldn’t stem the tide. While small- (the S&P 600 gained 1.4%) and mid-cap stocks (the S&P 400 gained 1.11%) did rally in February, large-cap and other equity indices declined. The Dow Jones Industrial Average and the NASDAQ fell 3.29% and 3.35% respectively, while the S&P 500 gave back 2.99%. International stocks fell by 1.95% and bonds lost 1.12%. Volatility surged, as the markets saw multiple days of several-hundred-point drops only to be followed by large rebounds. Whipsaw intraday action on several occasions was enough to give even seasoned traders headaches. Talk about change!

We've faced periods of rising interest rates before, where the markets were able to claw their way back from their initial negative reaction to Fed hawkishness. Likewise, we've seen the markets sell-off over geopolitical events, including war, only to recover within days or weeks. But when these events take place in the wake of massive amounts of government stimulus and in the midst of continued supply-chain issues that have disrupted spending behavior ... well, we've seen less of that, historically.

This perfect storm has economists and investors scratching their heads over how to respond to the data in a meaningful way. Our position is to stay diversified, hold steady, and not try to time the markets. There is a massive amount of data that shows that trying to time the markets doesn’t work, and returns suffer by attempting to do so. We've said it before, but it bears repeating: Missing just the five best days in the markets over the past 40+ years meant your returns were 62% of what they would have been had you stayed fully invested; if you'd missed the 10 best days, your returns would have been less than 50% of those had you stayed fully invested. The data gets worse the more days out of the markets you are.

The tough part is, many of the best days often occurred shortly after some of the worst days, meaning market timers, and those that panic, missed out on most of the rebound. The lesson is clear: Staying invested works!

Economy

The aftermath of the effects of COVID certainly are still with us and will be for some time yet, albeit to a decreasing degree.

  • Gross Domestic Product (GDP): Estimates remain in the 2.5% to 5% range, with most falling shy of 4%. Longer-term expectations of a slowing economy have not changed, and it continues to be likely that the economy will eventually revert to pre-COVID levels of activity, resulting in GDP gains of 2% to 2.5%.
  • Inflation: January data shows the rate of inflation rose 0.6% for the month and 7.5% over the past 12 months. This is the highest rate since the 12-month period ending February 1982. Unfortunately, the war in Ukraine has negatively impacted the price of energy (primarily oil and natural gas) and, as such, the February number will likely be higher. Some improvement in supply chains should help minimize the damage, however. Many economists predict inflation will fall as we proceed through this year and next, eventually dropping below 2% as it was pre-COVID.
  • Unemployment: The job picture may finally be improving! The labor participation rate is finally ticking higher, and wages are going up, although not as fast as inflation. The unemployment rate increased slightly to 4.0%, but the fact that more people are back in the workforce is a positive sign for the future. As mentioned last month, we are not surprised to see some of those who elected to retire early during the pandemic rejoin the workforce. Over the long term, the unemployment rate is expected to hover at, or be slightly less than, the full employment rate. This is not great news for our GDP, which depends significantly on the productivity of our workforce, and any job shortages will not help.
  • Other: The economic fallout of the war in Ukraine has yet to be fully felt. Higher gas prices will be around for a while, until domestic production can ramp up to meet the demand. Manufacturing activity is strong, and corporate profits and future guidance have been good, which should help the markets navigate through a somewhat tumultuous year.

Fed Watch

The question of whether the Fed will raise rates is no longer one of "if," but "when." And we seem to have an answer: Chairman Powell recently indicated the first hike would take place in March. Those expecting a 50-basis point hike will likely be disappointed, as he also indicated that the first hike would be just 25 basis points. Things are also a-changin’ rapidly with regard to the number of hikes expected this year. At the start of the year, most estimates were for two to four hikes, with more to follow in 2023. Those estimates moved to as many as nine (!) just a couple of weeks ago. Now, partly due to the war, most feel we'll see four to five hikes this year, and perhaps three more next year. With inflation expected to soften over the next 12 to 24 months, this makes sense, but estimates will change as the data changes. Rising rates can be bad for stocks, but with real rates still quite low even after the Fed raises them, equities should post solid gains.

Outlook/Summary

With all that’s going on, it's very easy for investors to turn bearish. In fact, many have, as bearish sentiment peaked at almost 54% in late February. This means that approximately 54% of advisors believed that the market would be negative over the next six months, compared to just 23% who felt it would be positive. The numbers have trended in the bullish camp over the past couple of weeks, with bearish sentiment dropping to 41% and bullish rising to 30%. Sentiment can be viewed as a contrarian indicator, where a large number on either side could be indicative of a peak in the markets or a trough. It's hardly surprising that the number is on the negative side right now. Remember what Warren Buffett said: “It is better to be fearful when others are greedy, and greedy when others are fearful.” Given the proclivity of change this year, sentiment numbers will likely be all over the place until the Fed makes a move, the war (and its effect on the economy) settles down, supply chains improve, and other economic data stabilizes. That is why we maintain our position of being diversified, but fully invested, concerned about downside risk by favoring hedged equity and floating-rate funds, and monitoring upside and downside capture ratios.

There are potential tilts that could be made toward energy, certain commodities, dividend-paying stocks with strong balance sheets, etc., and we will seek to take advantage of those as we deem appropriate. Keep in mind that the data shows mid-term election years are volatile, but a year later, markets almost always have recovered and then some. The same goes for the initial time frame of military conflicts, although the recovery in those instances tends to be even quicker.

We will monitor the Fed, the economy, and other news as we navigate through an interesting year that is sure to be full of change. To discuss your portfolio, please reach out to me or any member of our Wealth Management team at (608) 826-3570. We look forward to speaking with you.

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