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Macroeconomic outlook: How to keep your perspective in a bear market (June 2022)
Published by the Private Client Team at KJ Harrison Investors
One should never utter the words, “I’ve seen it all.” But those of us who have been in investment management for a while can comfortably claim that we have seen a lot. I started in this business in the late summer of 1998, just a couple years before the dot-com meltdown, when markets fell 60%. Several 20% drawdowns were scattered throughout the years after, and the Great Financial Crisis gave us a 50% haircut. Then the pandemic of 2020 sparked another crash (45% market decline from peak to trough). So, technically, this is my seventh official bear market.
I admit this is no great claim to fame, but here’s the point: not even half a year ago, markets were at an all-time high. Periods like this one, with a decline of about 20% from the start of the year, are painful to live through for investors – there’s no doubting that. But stretch your time horizon and think to yourself, OK, we’ve been through seven bear markets in the past 35 years, from the tech crash to the GFC to the pandemic, and every time the markets went on to hit fresh all-time highs. I am not saying this will definitely be the case once again, but it does seem likely. And a little perspective is healthy in times like these.
But what do we mean by “times like these”? Current macroeconomic factors have created a trifecta of headwinds for markets – namely, inflation, the monetary policy response to inflation, and the very real possibility of an economic downturn as a result of that policy response. A year ago, the U.S. Federal Reserve, which is the central bank that matters most, thought the inflation resulting from late-pandemic reopening would be transitory; now, it’s clear that inflation is much more structural. So the Fed is hiking rates – fast – and started quantitative tightening, which draws more liquidity out of the system.
The intent is clear: whip inflation by destroying demand. The Fed doesn’t have a choice. It can’t “print” oil or food the way it can “print” money. Hurting the economy is its only path to getting inflation under control. And at what cost? Probably, a recession. It might be a mild one. It might be a major one. The Fed seems to think it can thread the needle. We’ll see.
Which brings us to the third horseman of the apocalypse in our trifecta of pain: the real economy. As more data rolls in, it is becoming clearer that the other two factors are starting to hurt. Recently, two of the world’s largest retailers, Walmart and Target, revised down their earnings guidance. Like
other businesses, they are facing a tight employment landscape, continuing supply chain issues and more expensive energy, and all that is biting into margins. Also, the demand side of the equation is troubling. Consumption represents about 85% of economic activity, and consumers are hurting. Gas prices have doubled, food prices are up, rent is more expensive, and the average Joe and Jane have less money to spend on anything other than the essentials.
Those realities suggest that a corporate earnings recession is not only possible, but likely. Markets could test new lows or take another leg down. And here is where perspective is important. When it comes to wealth, people tend to lean not on the rational side of their brain, but on the emotional side. As they watch their portfolios bleed out over 10 or 12 or 20 weeks, as they have this year, it wears on people. We have seen basically the entire market run to cash, which makes everybody feel better. But then one day you have to look at your time horizon and see that you still have however long left to live, and you ask yourself, “If I’m not taking advantage of this environment now, then when will I?” Will you wait to put your cash back to work when the sun shines again and there’s more clarity? If you do, you might pay a heavy price.
That is because of the Fed. Yes, it is telling investors that it wants to hurt demand, but it cares much less about inflation than about jobs – the second part of its dual mandate. As Fed officials start to see evidence that rate hikes and QT are working (i.e., hurting the real economy enough to threaten employment), they will waste no time taking their foot off the throat of demand. One dovish comment from Fed Chair Jerome Powell, and the markets are likely to whip around to the upside. There is plenty of research to suggest that most of the returns in any given year occur in three to four days. A Fed turn could create just such a market event, and investors
sitting on their cash might not be able to get back in.
As bad as things look right now, we may be further along in this process than many investors realize. Multiples on stock valuations have compressed; the earnings of significant companies are coming down. The third leg would be the Fed saying it’s done enough. Obviously, we are not there yet, and there is no way to tell when it will happen. But we can reasonably anticipate that at some point – maybe the latter part of the year and into next year – central banks will capitulate. Whenever that happens, it will create an amazing opportunity for risk assets.
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