The past almost two years have not been easy for investors. In 2022 the S&P 500 index was down -18.1% and the Barclay’s Aggregate Bond index was down -13.0%. The worst year for the bond market in over 100 years. In 2023 the S&P 500 is up +13.1% (as of Sept. 30), which is nice, but still doesn’t get us back to where we started at the end of 2021. The bond market, however, is down again in 2023 at -1.2% (as of Sept. 30). Nothing dramatic, but many analysts, us included, felt 2023 would be a recovery year for bonds and fixed income given the routing they took in 2022. Clearly, that has not been the case.
Looking a bit more closely at the S&P 500 index we see that after a bumpy ride in early 2023 the market had strong gains from early March to late July. The index was up about +18.8% in late July. Then came August, September and into October where the market waned. It has dropped -10.4% as of October 25, 2023. Bonds have not had a similar run. After hitting a peak in early February, the Barclay’s Aggregate Bond index has gradually moved down since. This continued drag of the bond market means that conservative investors, whose portfolios often have greater bond exposure to curb their risk level, have been hit harder than more aggressive equity investors. A very unusual set of investment circumstances
And the Counter-Argument?
The thing that makes this market so difficult to understand, and predict, is that the underlying economy continues to show remarkable resilience. For starters, the latest Gross Domestic Product (GDP) level was announced at +4.9% annual. For a large, developed economy such as the U.S., that is a very impressive level of growth. On top of that we have an unemployment rate that is historically very low at 3.8%. Then we have Industrial Productivity near historic levels after dropping in 2020 during the pandemic but climbing back strongly since. Add to this the fact that we have corporate earnings which are down slightly in 2023, but still remain at historically high levels after large gains in 2021 and 2022. Finally, looking at expected bond default rates, they are up slightly in 2023, at least in part because of the recession that’s been expected all year. But the expected default rate remains near historic lows. All of this points to an economy that is quite strong and should be very supporting of both the stock and bond markets. But since August of this year we have not seen market support in any way.
So, we have a strong underlying economy, but we have a stock market that has been stuck since August of this year and a bond market that has been stuck this entire year. What do we think is happening? We believe the entire market situation comes down to inflation and the Federal Reserve Bank’s (Fed) ongoing response. Inflation started ramping up in March 2021 when the Consumer Price Index (CPI) came in at +2.6% annual, higher than the Fed’s target of +2.0%. The CPI continued to go up into 2022 where it reached a peak of 9.1% in June 2022. CPI did start to slow from there hitting a low of 3.0% annual in June 2023, but has climbed higher and now sits at +3.7% as of September 2023. The Fed has raised interest rates starting in March 2022 from a low of 0.0 to 0.25% up to today’s rate of 5.25 to 5.50%.
Raising interest rates is supposed to slow the economy and help tame elevated inflation. But given the most recent GDP reading, the economy doesn’t seem to be slowing. As a rule, markets, and particularly the bond market, do not like rising interest rates. And given the recent levels of CPI, and the most recent GDP report, it appears the Fed will need to at least hold rates at the current level for an extended period or raise rates further to push the economy toward slowing. Either one of those scenarios is not market favorable. And the overall market narrative seems to have shifted almost entirely to the issue of inflation and interest rates…GDP, unemployment, industrial productivity, corporate earnings and bond default rates be damned. Keep in mind that historically, when the Fed raises rates aggressively, it has slowed the economy and sometimes to the point of recession. Recession has been a fear all year as rates have gone up, but so far we’ve not seen anything that looks like a recession.
Where From Here?
We believe that both the equity and bond markets will rally, but it’s going to require the Fed to reassure the markets that rates are not going up further. After the September Fed meeting, they held a press conference where they made it very clear that rates may continue to go up, and that their decision will be data dependent. Well, the most recent data has a CPI report that was somewhat disappointing at the +3.7% level given that August was also at +3.7%. And, we now also have a GDP report at +4.9%, further suggesting the economy does not seem to be moving where the Fed wants, and that inflation may continue to stay elevated. The fact is that +3.7% is still far off from the Fed target of +2.0% and the Fed knows they need to see it head toward that +2.0% level. Will they raise rates at either the November or December meetings? We don’t know. At the moment, markets don’t seem convinced that rates will go up, but they do seem convinced they will stay at current levels for longer.
Historically, once the Fed stops raising rates, they start reducing rates to encourage the economy to recover from slowed or recessionary levels. We don’t feel that the markets need to see falling interest rates in order for them to start to normalize and recover. We feel that if the Fed stops raising rates, and makes it clear rates will not increase further, the recovery can start. Given the difficulties with this market over the last two years we can’t say for sure that the markets can start recovering before interest rates start falling, but we think they can. We feel the markets need to know rates are done going up, and that will be enough for normalization. No guarantees, but we’ll see. The good news for long term investors is that after very strong positive market years in 2020 and 2021, for anyone who has been invested for at least three years, they are still up. Not up as much as at the end of 2021, but still up. Thus, we feel being patient with this market and staying invested to benefit from the recovery is the best approach.
All the best,