Earlier this week, markets slid sharply on interest rate jitters after a less-than-favorable inflation report pushed the S&P 500 lower by 4.3% on Tuesday – the largest daily decline since June 2020. Investors had recently turned more optimistic on the chance for a possible soft economic landing following better-than-expected corporate profits, job growth, and declining commodity/energy prices. While the August data released on Tuesday showed that headline inflation rose just 0.1% over the month of July, investors reacted negatively to news that the “core” figure (excluding volatile energy prices, which saw a large drop over this time period) ticked up from 0.3% in July to 0.6%. The core figure is more reflective of broad-based inflationary pressures, and this monthly pace suggests an annualized rate greater than 7% – far too high for our central bank to consider slowing down its aggressive rate tightening campaign and all but guaranteeing a hike of at least three-quarters of a percentage point when the Fed meets next week.
It makes sense that this latest inflation data was not well received since the stock market doesn’t like the cost of money to rise ─ higher interest rates can reduce corporate profits and increase the rate at which future profits are discounted back to today, both hurting valuations. Unfortunately, Tuesday’s downturn erased the month-to-date gains and places the market squarely back to where it ended August. As for bond markets, the yield curve remains inverted, and the two-year treasury note offers investors a rate of nearly 3.8%, which implies the Fed will continue to hike rates into early 2023 before potentially reversing course as growth (and hopefully with it, inflation) begins to moderate to more acceptable levels.
Financial markets were expecting further softening in the monthly core CPI figures, with the hope that two data points might foreshadow a sustainable trend. What this report makes obvious is that inflation is not only somewhat unpredictable on a month-to-month basis, but it is also very hard to break once it has momentum. Until there’s a clear break in inflation, investors will likely continue to have their doubts in the face of bad news, making a sustained upturn more difficult. However, the Fed has made it clear they will not tolerate higher inflation becoming entrenched and will use their full toolkit to ensure that consumer and business demand is dampened sufficiently to cool underlying price pressures in the economy.
We are now in the ninth month of this malaise, which and that approximates the typical length of time that a bear market persists assuming the economy does not fall into a recession. Over the past century, U.S. stocks have averaged positive returns over one-year, three-year, and five-year periods following a steep decline such as this. While steep downturns such as the one experienced earlier this week are unnerving, they can often be followed by similarly strong upturns as the fundamental data simply moves from bad to “less bad,” even when the data is still somewhat negative.
This market behavior often perplexes and frustrates investors still sitting on the sidelines. A silver lining? After more than a decade of depressed returns for savers, the entry point on bonds looks more compelling than it has in years, with the two-year treasury yield back to levels not seen since 2007. Furthermore, seasonality often turns more positive at this time of year, and the midterm election cycle often bodes well for stocks once we turn the page on September (see chart).
According to Bespoke Investment Group, midterm years are notably weaker for the stock market relative to all other years, and the low for the year in midterm years typically occurs at the end of September. From there, performance tends to be strong through year-end of the following year, with an average gain of 23% compared to just under 13% for all years since WWII.
While the past certainly does not always repeat itself, the historical track record is worth considering. The JNBA Investment Committee will continue to manage risk prudently as we watch closely for signs of recession (e.g., initial jobless claims and consumer sentiment) amidst the Fed’s battle to bring inflation under control, while also taking into account the higher bond yields and cheaper equity valuations currently offered to those willing to take a longer-term view.
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