In recent weeks, we've seen significant market volatility in response to the Federal Reserve hiking the federal funds rate another 75 basis points, hoping to tame what is proving to be somewhat sticky inflation. During their meeting, they indicated that they would do whatever it took to stamp out inflation, including tolerating an economic recession and would likely raise rates another 1.5% by the end of the year. As we prepare for continued volatility, we want to share some of our thoughts on the economy that will hopefully help you weather this current season within the context of your greater financial legacy.
By some measures, we have already entered a recession. Real GDP was negative in the first two quarters of the year and was slightly positive in the third. Financial markets have remained depressed for some time now and look less confident about the future. By other measures, the economy is still churning along. The most notable outlying indicator is unemployment which remains at a generally low level despite economic pressures. In a typical recession, we would expect unemployment to begin to increase, and it still may. However, the labor market is facing external demographic pressures that have been years, if not decades, in the making that will continue to strengthen the labor market even as the economy strains. Economic growth comes from innovation (we get more efficient at making things) and growth in the labor force, which can come naturally through higher birth rates or the migration of workers. Birth rates have been trending down for many years now, and that, in combination with an influx of early retirements during the pandemic and a much slower pace of immigration, has led to fewer workers – a trend that will continue to cause wage pressures in opposition to the ongoing battle to wrestle inflation down.
In other parts of the economy, we are seeing inflation soften. It’s just not softening at the rate fed officials hoped it would, and this is in large part because consumers are still tolerating higher prices. As long as individuals are willing and able to pay elevated prices, inflation will continue. However, consumers are more and more beginning to feel that pinch and are beginning to adjust their buying patterns accordingly. In particular, home prices are starting to drop, which comprise a significant portion of the Consumer Price Index, as do energy prices, and we’ve also seen gas prices fall. Food prices, however, have held on both because grocers are trying to hold on to wider profit margins and because transportation continues to cost more due to higher labor costs, even as gasoline has become a bit cheaper. Altogether, we see lower inflation on the horizon; but it’s materializing slower than many had hoped.
What does this mean for our investment outlook? We now believe that with a recession more likely, we will likely see increased volatility for the foreseeable future. Furthermore, we expect this on both sides of the market. Regarding equities, higher interest leads to higher borrowing costs for companies and consumers. Higher costs lead to tighter margins and lower earnings, which will constrain prices until corporate innovation finds a way to enhance profitability in other ways. What is unique about this economic environment is that higher interest rates also have a negative impact on bonds. If the market requires borrowers to pay more for money borrowed, they will borrow less. Fundamentally speaking, this leads to an inverse relationship between bond yields and bond prices, so as rates rise, prices will fall. This means that yields have become increasingly attractive as it stands, and we’ve been touching base with all of our managers on what opportunities might be out there.
Regarding your personal finances, we’d like to reiterate that our plans have built volatility like what we’re experiencing now into our assumptions. Our financial plans assume average annualized returns of roughly 6.55% for equities in the future, with returns closer to 3.05% for bonds. In reality, market returns are not that smooth, with returns varying from year to year but averaging in those ranges over time. Consider the following chart:
Despite the rapid selloff and subsequent recovery we experienced during the pandemic, returns over the last decade have been significantly higher than long-term averages, with double-digit years seen by equity markets in many of those years. Given that demographic growth has shifted and many emerging markets, including China, have slowed as they’ve become more developed, we have long expected a lowering of returns, and a pullback like the one we’re experiencing is expected from time to time. That being said, the future is hard to predict, as are the specifics of this selloff. In the middle of the summer, it looked as if we may have seen the worst of it, and markets began to pick back up. Now, it’s looking like there may be more volatility yet to come. While it’s tempting to try to exert control over an uncertain environment and “do something,” we again caution against trying to time this selloff. As we mentioned earlier, while it hurts to be at these lower levels, they also mean great potential for the rebound in the mid and long-term as both the economy and markets stabilize and recover. We don’t want to miss that recovery.
For many of you, this is the first true selloff you’ve experienced in recent memory, and we know it is uncomfortable to sit through it. As always, we encourage you to call us with any questions or needs you may have. Many of you have recently completed our annual review questionnaire and/or had a review of your financial plan done, and we want to thank you for assisting us with that process. We have been reviewing our plans to ensure that they continue to be on a strong and stable path. We are happy to sit down with you and walk through your plan to offer you some peace of mind during these trying times. We remain grateful for your trust and support and are here for whatever you may need.