Making Sense of our Economic Landscape
“Cast me gently into morning,
For the night has been unkind.”
-Sarah McLachlan, “Answer”
With so many developments and crosscurrents in our current economy and investment markets, it can be difficult to make sense of where we are, not to mention where we might be going. Here, we’ll take a look at some of these forces at play, and talk in plain English about their financial implications for us all.
First, let’s review where we find ourselves and how we got here. Both the stock and bond markets have suffered punishing losses so far in 2022. That alone is quite a reversal of the nearly two years prior. From March 16, 2020 to November 1, 2021 the total US stock market climbed 110% as measured by the Vanguard Total US Stock Market Fund. In 2022 through June 29, these same stocks have declined 21.2%. It’s enough to give investors whiplash. And those extraordinary 2020-2021 gains came in the teeth of a global pandemic. Even this year, the economy and employment have been healthy. Yet the investment pain has been widespread. How can we explain these wide swings in prices? There are a couple of dynamics to keep in mind:
One is that the stock market is a forward-looking mechanism. What does that mean? It describes that investors bid stocks up or down based on their expectations of companies’ prospective earnings in the future relative to their prices today. Companies with glowing futures – think of Apple or Google – would engender a high level of confidence in their future earnings potential. Are they good investments? Only if their current market prices don’t adequately reflect that future level of earnings. From any given moment, investors who wish to change their investments must decide the following: Will companies be making more money in the near future than is generally believed? Less money? Current prices reflect the current consensus thinking on the level of those future earnings. By this measure, what does it take to know if stock prices will be higher or lower in the near future? Yes; knowing the future. Therein lies no small part of the challenge with the idea that an investor can consistently outperform the market. What makes markets move, then? One primary driver is new information which causes investors to shift their cumulative beliefs about future earnings. We can trace a considerable element of our recent stock (and bond) market volatility to changing real-world conditions giving investors evolving or even rapidly changing perspectives on the near future of corporate profitability.
Another factor in markets’ sometimes wild swings in prices is that investors don’t by any means act in consistent and perfectly rational ways in their analysis of the world around them, and therefore whether stocks or bonds appear cheaper or more expensive today than they did yesterday. Increased uncertainty sparks investors’ fear. Unexpected good news can foster greed. History shows that markets tend to overshoot “fair value” on the way up, and oversell on the way down. After all, it’s not easy to resist the wish to be part of a rising market, just as it requires uncommon fortitude to buy into a declining one.
For some perspective, the stock market has advanced 56% over the past five years – including this year’s declines. That still exceeds stocks’ long-term average return. In fact, going back to March 2009, US stocks have been on an upward tear placing its gains among the strongest in market history. That it would give back a portion of those gains sometime is not abnormal. Stock prices can remain elevated relative to companies’ projected future earnings for considerable periods of time. They can also remain relatively undervalued for extended periods. This is due primarily to investors’ enthusiasm for owning stocks, something based in human emotion rather than in mathematical formulae. That stocks do not plod along in a nice, peaceful, predictably steady upward trajectory is what both turns all of our stomachs in times like these, as well part of what makes these “risky” assets historically such strongly appreciating long-term investments.
During the pandemic lockdowns in early 2020, millions of new investors opened brokerage accounts in the US and worldwide. One of the forces they brought with them is captured in the acronym FOMO: Fear Of Missing Out. While applied most commonly by younger generations towards life adventures or experiences, we can see the influence this adrenaline can have on market pricing, specifically by adding upward pressure to already potentially inflated asset prices. From “meme” stocks to tech stocks to energy stocks to other part-time darlings of investors’ short attention spans, we have been served up yet another reminder that some of the most precious elements of wealth building include perspective, balance, and patience.
For many of you, bonds are a central element to your investment portfolio. Bonds have faced their own set of seismic shifts in their environment which have caused this historically complementary asset class to be much less helpful this year in mitigating stock market losses. One quick note on bonds: as their prices fall, their dividend yield rises. Bond fund investors who’ve suffered losses will enjoy positive total returns with sufficient patience through higher cumulative dividend income. What will influence markets looking forward? Truthfully, anything which changes our collective outlook on the world, and specifically the business world, can be material to future stock and bond returns. But of course there’s one factor which has played an outsized role in market participants’ minds: Inflation.
There have been numerous factors influencing prices for goods and services, as you know. Notably, the pandemic coupled with the war in Ukraine have led to production shortages and transportation inefficiencies, together with shifts in consumer demands and inventory planning difficulties, have driven prices higher at their fastest rate in forty years. This leaves the Federal Reserve in the unenviable position of managing interest rate policy. Their challenge: Raise interest rates high enough, fast enough to cool inflation; but not so high or fast as to cool the economy into contraction, meaning recession. The good news is that the Fed is stocked with exquisitely talented women and men. The bad news is that the nature of their job is akin to driving in the dark without headlights: they must not accelerate too fast and increase their risk of crashing into an unseen object, but they must not plod too slowly and risk being hit from behind. The Fed is forced to use historical data on an evolving economy to set current policy. It’s a daunting challenge.
While keeping the economy out of recession is a primary focus of the Fed, Chair Jerome Powell recently testified before Congress that he and his colleagues are even more adamant about moderating inflation. Two things that must keep central bankers awake at night are inflation and deflation. They Fed appears willing to tilt towards the aggressive side in their interest rate policy with the aim of moderating inflation, forecasting several more incremental rate hikes over the course of this year.
Why does the Fed fear inflation so? The answer is familiar to anyone who remembers the late 70’s and early 80’s. It is the fear of what President Jimmy Carter so eloquently described in his speech on July 15, 1979 as “a crisis of confidence.” The concern with inflation is that it can be a self-fulling prophecy. If people believe that prices will rise quickly, it can contribute to prices accelerating. Confidence is central to the Federal Reserve’s strategy of monetary policy in 2022. The environment of darkness and pessimism which President Carter described is palpable. It is this public mindset which the Federal Reserve is focused on averting.
Beside the implications for our nation, this interest rate dynamic bears relevance to investment markets. As we’ve illustrated, asset prices reflect perceived value of those assets. Herein lies the tug-of-war on stock and bond prices today. How high will inflation be, and for how long? Higher interest rates make companies’ future earnings appear less valuable in today’s dollars. “Growth” stocks, such as those tech stocks I mentioned earlier, tend to be more susceptible to higher interest rates relative to “value” stocks, which tend to be less glamorous names. Higher interest rates also raise companies’ employment costs, and borrowing costs for future projects, such as building new plants. They also make bonds’ rising yields look relatively appealing, placing some competition on stocks for investors’ dollars.
Will the US (or the globe) recede into recession, meaning economic growth slowing to the point of becoming negative compared to the prior year? A slowing economy equals fewer corporate sales, therefore warranting lower stock prices. It can also lead to declining investor confidence, as we’ve described, reducing investors’ willingness to pay as much for those future company earnings.
These are some of the dynamics and variables which we are watching, incorporating the ever-evolving influences on our capital markets and your wealth. As always, we will filter these conditions through our years of experience and perspective, adjusting where appropriate, remaining focused on the enduring principles of sound investment which have served us well over the decades.
Investing opportunity is born of pessimism. When investors’ confidence in interest rates, economic growth, and all the factors surrounding business outlook slip to the point of greatest weakness, the investment future, ironically, will be brightest. Know that we’re all in this together. Morning will once again come, and we will appreciate and enjoy it.
