Market Perspective: Volatile Times
Article authors: John Allen, Stephen Kawasaki, Chase Arima
The current volatility can feel unsettling, even for the most experienced investors. High inflation is causing the Federal Reserve to raise interest rates, which is expected to weaken employment and economic growth. But even in bear markets, there are often attractive investment opportunities for those with a long-term mindset.
As the Federal Reserve continues tightening monetary conditions, resurfaced recession fears have dashed hopes for a soft landing,1 and triggered equities to resume the selloff that began earlier this year. While this may sound familiar (perhaps from a recent Fathom post), the most recent round of volatility occurred after the Federal Reserve communicated their resolve to corral inflation by increasing short-term interest rates2 to approximately 4.5% by the end of the year. If reached, that would drive interest rates 4% higher than they were at the beginning of the year, dramatically weighing on consumers’ and homeowners’ willingness to spend and buy. The Fed also communicated the potential to maintain its restrictive policy for longer than previously anticipated. Restrictive monetary policy, by design, aims to address elevated inflation by decreasing the demand for goods and services, however it is typically accompanied by below-trend growth and softer labor markets.
For now, the Fed appears committed to pushing interest rates as high as needed to cool inflation, despite these potential consequences. The Fed’s determination relates to the inflationary consequences impacting everyone, especially those least able to meet higher costs for essentials like food, housing, and transportation.
A muddled economic picture domestically comes at a time when Europe and other countries grapple with their own challenges, including political, economic, and military conflicts. Furthermore, U.S. equity valuations remain elevated, especially for growth stocks, given the potential for a corporate earnings recession in the months ahead. While actual earnings tend to fall by 20-30% in typical recessions, current earnings expectations defy history and still reflect elevated growth rates over the next few years. We expect future earnings to fall well short of those lofty expectations.
The market’s consternation swirling around the economic environment, including the potential for recession, are reflected in the VIX Index,3 or commonly called “Fear Gauge,” which recently hit its highest level since mid-June.
Silver linings amid uncertainty
Although market sentiment has waned, our focus continues to be on preserving capital and taking advantage of pockets of opportunity within diversifying strategies, defensive equities, non-U.S. equities and value equities.
Additionally, while rising interest rates caused bonds to underperform so far this year, bonds now carry a higher coupon and have historically benefitted from interest rate hikes over the 24-month period following tightening cycles, as shown below. Consequently, we believe maintaining a meaningful allocation to fixed income will serve investors well in the months ahead.
We know today’s market volatility and the possibility of further market declines is a concern. It is certainly possible, if not probable, that markets get worse before they get better. However, it is important to remember that falling prices create more inviting entry points for patient, long-term, valuation-sensitive investors. Although today’s market volatility feels unsettling, remaining diversified and working with an experienced advisor can help you stay on track with your financial plans.
1A “Soft landing” is considered a scenario where inflation is brought down to the Fed’s target rate of 2% while avoiding a recession and corresponding increase in the unemployment rate.
2The Federal Funds Rate.
The “VIX” Index is the ticker and name for the Chicago Board Options Exchange’s CBOE Volatility Index, which reflects the market’s expectation of volatility based on put and call options on the S&P 500 index.
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