A defining characteristic of the investment environment this year has been an oscillating market driven by a rapidly changing set of facts and overall investment narrative. We started the year with optimism that we would move beyond COVID-19 and enter a period of slower but more normalized growth. However, investor sentiment plummeted following an inflationary perfect storm. A reacceleration of core inflation, Russia’s invasion of Ukraine, and dramatic market repricing of monetary policy expectations led the market sharply lower. A chorus of recessionary warnings could be heard building through the second quarter. Downgrades of corporate earnings guidance, particularly from retailers like Walmart and Target, have been equally jolting.
The facts and narrative made another about-face this summer, with the S&P 500 rallying 17% in two months.1 Better-than-expected earnings, signs of peaking core inflation, a reversal in interest rates, and receding commodity prices all contributed to optimism—and maybe a bit of FOMO (fear of missing out)—for equity investors. Also underpinning market momentum was a belief, evident in investment industry commentary and fed funds futures pricing, that the Federal Reserve (Fed) would “pivot” toward rate cuts almost immediately after reaching the peak fed funds rate for the cycle. As of July 31, the futures market was pricing a peak fed funds rate of 3.3% in December 2022 and 60 basis points or bps (0.60%) of rate cuts by December 2023. In other words, the Fed would achieve victory over inflation by early next year then immediately begin to ease policy, an echo of the “soft landing” achieved in the mid-1990s. What is often missed is the fact that the S&P 500 went nowhere during the Fed’s 1994 rate-hike cycle and only took off after the Fed stopped tightening in early 1995. Today’s inflationary conditions make the comparison ill suited.
The effect of the market pricing rate cuts in 2023 was that the peak fed funds rate diminished in importance, and the market looked ahead to easier financial conditions for the balance of 2023. Shares of smaller, riskier, more leveraged, and higher-valued companies all outperformed. While we had communicated our expectation that the fed funds rate will top out at around 3.25%–3.50% we have been skeptical of the view that inflation data would compel the Fed to begin cutting rates by the second quarter of 2023. We resisted any temptation to chase the summer rally, holding a neutral allocation to equities versus our strategic benchmark (since June), maintaining excess levels of cash, and focusing on quality stocks.
Indeed, Fed Chair Powell’s speech at Jackson Hole on August 26 was intentionally shorter and more direct than in past years. He emphasized combatting inflation as the Fed’s chief priority. Importantly, he also poured cold water over the thesis that the Fed will soon pivot away from tightening policy, referencing the mistakes made in the 1970s when policymakers let down their inflationary guard too early. He, like the rest of us, welcomed the improvement in inflationary data but made it clear that one month does not a trend make. The market narrative was recast again.
So where does that leave us?
The S&P 500 retreated 8%2 since August 16 and closed August approximately 17% off the January 2 highs. It is possible that a disappointing August Consumer Price Index (CPI) report could lead to the market retesting the June lows. However, as long-term investors we are focused on returns 9–12 months from now, and over this longer timeframe we maintain conviction that inflation will acutely decelerate leading to strength in the equity market.
1The S&P 500 index returned 17.4% between June 16, 2022 and August 16, 2022.
2As of August 31, 2022. Source: Bloomberg.
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