EDUCATIONAL RESOURCES

Market Update

The Current Market Decline, Explained

Presented by John B. Steiger, AIF®, CFP®

When you see the current headlines, you may be asking yourself: why is the market going down? The short answer is interest rates. Interest rates are going up, and when rates go up, stocks tend to go down. This leads us to ask additional questions—why are interest rates up? And will they continue to rise? In the short term, it seems they will indeed continue to increase. Here’s why.

A Message from the Fed
Last Friday, Federal Reserve (Fed) Chairman, Jerome Powell, spoke at the annual Jackson Hole central banking forum. His prepared remarks reinforced the Fed’s current view that restrictive monetary policy will need to be in place for some time in order to combat inflation before we start to see easing policy and lower rates. In other words, Powell was quite clear that the Fed intends to get inflation under control, and that it will keep hiking interest rates—even as the economy moves into a recession. This is new.

Before last Friday’s speech, markets were pricing rate hikes through March of next year, but then expecting rate cuts shortly thereafter. As a result of Powell’s comments, though, markets are now expecting those rate cuts to be delayed until at least the second half of 2023. So, rather than counting on limited rate increases and quick rate cuts, Powell confirmed that the increases will be larger, and the cuts more delayed than anyone expected.

The rate on the 10-year U.S. Treasury note rose from about 2.6 percent at the start of the month to over 3.1 percent. That’s a big jump, especially over a short period, and it has hit the stock market hard for several reasons.

Effects on The Market
First, higher rates pressure valuations for equities, especially for stocks that have recently outperformed and have high valuations on a historical basis. Additionally, the tighter policy and higher rates are designed to slow economic activity to combat inflation, which could negatively impact earnings growth. Lower valuations and lower earnings mean stocks drop, as we just saw. And this isn’t the first time—or even the first time this year—we have seen this reaction.

However, just as with earlier this year, that initial market reaction doesn’t necessarily hold over time. While we should expect more volatility, there is a real possibility the Fed will end up hiking less, and cutting sooner, than Powell’s speech seemed to suggest. With inflation showing signs of peaking, and with growth slowing, the economy is already responding to higher rates. This means there may be fewer hikes necessary in the future. When the data changes, so will expectations, and the market will react.

The Key Takeaway
The real message behind Powell’s speech and the market reaction: expectations rule the market, and those expectations can change quickly with new data. Given current expectations, that new data is now more likely to be positive (rather than negative) for markets.

Notably, we’ve seen interest rates bouncing around between 2.5 to 3.5 percent over the past six months or so. This large range reflects the uncertainly around where inflation is going, what the Fed is likely to do, whether we’re in or headed for a recession, and so forth. Depending on the data releases, markets can push rates up or down, and then back again.

Most recently, the Fed has been hawkish, which drove rates up through June. Then, with growing economic weakness, markets drove rates back down through early August based on the expectation that a recession would force the Fed to cut rates. Now we are starting that cycle all over again with the hawkish Fed. So, rates are likely to rise through the end of the year, but that will slow the economy over time and raise expectations of rate cuts. Then we will be back to square one.

The Bottom Line
What does all this mean? In the short term, it probably means higher rates and more pressure on the stock market. In the medium term, however, rates will likely come down again. For the stock market, the fact that those higher rates are now expected should limit the damage going forward and increase the chance of a bounce when expectations change.

Now back to the original question: will the market keep going down? It’s possible the decline will continue
for a while. But, overall, this is all a normal cycle of policy and reaction, not something worse.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

Market Update for the Quarter Ending August 31, 2022

Presented by John B. Steiger, AIF®, CFP®

Markets Drop on Late-Month Sell-Off

August proved challenging after a late slide caused by rising interest rates dropped all three major indices into the red. The S&P 500 lost 4.08 percent, the Dow Jones Industrial Average (DJIA) dropped 3.72 percent, and the Nasdaq Composite fell 4.53 percent. The sell-off was caused in part by comments from Federal Reserve (Fed) Chairman Jerome Powell, who said the central bank would keep short-term rates higher for longer to combat inflation.

Fundamentals showed improvement. The blended earnings growth rate for the S&P 500 in the second quarter was 7.8 percent, according to Bloomberg Intelligence, beating analyst estimates for a more modest 4.1 percent increase. Technical factors, however, were worrisome. All three indices ended the month well below their 200-day moving averages. This marks five consecutive months with all three finishing below trend, which is a cause for concern because prolonged breaks above or below a 200-day moving average can signal changing investor sentiment.

Concerns about tighter global monetary policy weighed on developed market investors. The MSCI EAFE Index dropped 4.75 percent, while the MSCI Emerging Markets Index eked out a 0.46 percent gain. Both ended August below their 200-day moving averages and have finished below trend every month this year. Fixed income markets also experienced sell-offs. The Bloomberg U.S. Aggregate Bond Index lost 2.83 percent while the Bloomberg U.S. Corporate High Yield Index lost 2.3 percent.

Fed Pumps Brakes on the Economy

July consumer and producer inflation reports showed slowing inflation on a monthly and year-over-year basis, and the Fed’s preferred inflation metric—personal consumption expenditures—declined modestly. Nonetheless, Powell reiterated late last month that the Fed will keep monetary policy tighter until it sees sustained progress in reducing inflation. This signals that rate hikes are likely to continue—even in the face of a slowing economy.

Figure 1. Existing Home Sales, 2011-Present

Source National Association of Realtors/Haver Analytics

As higher interest rates have started to bite, the economy does indeed appear to be slowing. Business and consumer spending dipped in July, and durable goods orders were flat. Retail sales and personal spending growth also slowed and came in below economist expectations in July. Housing has seen the largest slowdown this year. The average 30-year mortgage rate increased from 3.3 percent in January to 5.95 percent at the end of August. As shown in Figure 1, the pace of existing home sales has slowed notably, from a peak of less than 6.5 million in January to roughly 4.8 million in July.

It’s important to note that the economy remains in a relatively good place. July’s employment report showed that more than 500,000 jobs were added during the month, more than double economist expectations and an encouraging sign that fundamentals remain healthy despite headwinds.

Faster growth could be ahead. Both major measures of consumer confidence showed notable signs of improvement in August, which could bolster future consumer spending and support economic growth. Business confidence also remained in expansionary territory in July, which should support continued hiring. Although we’re likely to see a slower growth economy for the rest of the year, slower growth is still growth, and the momentum from earlier in the year should help us avoid a recession in the near future.

Markets May Face More Turbulence as Uncertainty Remains

The economy may be resilient, but markets remain susceptible. Markets and economists have largely expected higher rates throughout the year, but the August sell-off after Powell’s comments is a reminder that even moderate surprises can lead to short-term volatility. It’s likely the Fed will continue to raise rates throughout this year and the start of next. While the hawkish surprise in August frightened markets, the expectation for higher rates in the short term is now priced in.

The path forward remains cloudy, and more volatility is likely. With most of the potential bad news priced in, however, upside opportunities remain. Given the potential for more market turbulence in the short term, the best strategy is to have a well-diversified portfolio that matches goals with timelines. As always, if you have questions, contact your advisor to discuss your financial plan.

All information according to Bloomberg, unless stated otherwise.

Disclosure: Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Bloomberg Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Bloomberg government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Bloomberg U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, and Sam Millette, manager, fixed income, at Commonwealth Financial Network®.