During recent trading sessions, several major market indexes have entered what is considered a correction, with prices down 10% or more from their recent highs. Given the continuation of this current selloff, we wanted to take a moment to examine some likely contributing factors to the market’s behavior and offer our perspectives on the present economic environment. When presented with any volatility, it’s important to remember that downturns are part of the investing process. While that may be uncomfortable for us, they are inevitable and, more often than not, are further exacerbated by the emotions of all those involved. As the headlines continue to dramatize the current cycle, we want to be grounded in the fundamentals of economics and investing so that we may healthily weather the storm.
The Federal Reserve
While there are many contributing variables to the market’s current behavior, one of the more significant factors is the current outlook of the Federal Reserve. The last few years have seen easy policy – both fiscally and monetarily – with large amounts of money flowing into the economy from both stimulus checks and Fed bond purchases. All of this, coupled with low-interest rates, has led to a very favorable economic environment, as illustrated by impressive corporate earnings even in the face of struggling supply chains. As the pandemic continues to retreat and normalize, these policies are beginning to shift as inflation, a common consequence of easy money, continues to drift higher.
In response to inflationary pressures, the Federal Reserve is ending its bond-buying program and signaling that it will likely raise interest rates several times both this year and next. The plot below offers some insight as to where interest rates may be headed, given what the Federal Open Market Committee has indicated so far.
As the federal funds rate rises, other rates will follow suit, and access to money will become more expensive than it has been in the recent past. Couple this with the end of many stimulus programs that were put in place during the pandemic, and we find ourselves in an environment where money has begun to dry up. Consumer behavior inevitably follows suit, and we see that play out in lower corporate earnings as purchases slow and margins are squeezed by higher costs including that of rising wages. Given that P/Es (price to earnings ratios) have been noticeably above average in recent years, it is unsurprising to see prices fall as earnings normalize. The graph below shows the forward price to earnings ratio relative to historic averages, to give you some idea of this divergence.
On a more general note, market volatility is also an indicator of meaningful uncertainty. In addition to a shifting economic landscape resulting from a global pandemic, we’re also facing the geopolitical uncertainty of what is transpiring in Ukraine. Ultimately, we don’t know what will happen there, nor do we know what the economic fallout will be, though many economists expect it to be limited given what we know so far. Nevertheless, the markets are a bit skittish as we wait for that conflict to play out and offer more insight into the consequences.
While it’s tempting to allow the present uncertainty and inevitability of change to feed market-related anxieties, as mentioned earlier, we need to remain level-headed and grounded in what we do know. Over the long run, the market has historically trended upward. Up close, however, that trend has zigged and zagged in its efforts to seek the right intrinsic value in an ever-changing world. Market corrections are part of the mean-reverting process by which markets seek appropriate valuations for any given asset. Granted, not all selloffs should be considered corrections. In March of 2020, the market sold off significantly, not because it was previously incorrect, but because a global pandemic had changed what was appropriate for valuations at the time (and because emotions were involved, the selloff was likely exacerbated as illustrated by the consequent correction upwards). We don’t think that is what’s happening right now. Nothing major has come out of the woodwork. Instead, a collection of smaller factors have converged to produce a less favorable environment for financial markets than we were previously faced with.
Nevertheless, the overall economic data continues to be positive. Unemployment, while not at historic lows, is still low. Overall, personal and corporate balance sheets remain healthy. From a portfolio standpoint, we are reminded of the value of diversification in moments like this. Notably, our focus on fundamentals on the equity side has done well recently, particularly given that value often outperforms in inflationary environments. Furthermore, our decision to engage with more active managers on the bond side is rooted in the belief that there is room for opportunity in spaces of uncertainty where specific knowledge holds great value even as expectations for bond performance overall remain low. We will continue to monitor these positions in the coming weeks as we keep a close eye on the markets and the news coming out of the Federal Reserve.
While we hope to offer our perspectives and give you some context for what’s going on, we nonetheless know that downturns can be difficult to stomach. As always, we remain here for you – whatever your concerns are. Should you find yourself anxious about the current market behavior or want to revisit your personal financial plan and the investment assumptions built into that plan, please don’t hesitate to reach out.