September Investment Comments
Timing the market is futile. Recall March 9, 2009. Unemployment was skyrocketing, large banks like National City and Washington Mutual had been shut down, and GM and Chrysler were teetering on the edge of bankruptcy and threatening to take down the whole automotive supply chain with them. Things were bad and more bad news was ahead of us. What a foolish time to invest in stocks! Yet, that was the bottom. Why? Because the sellers had finished their selling. However, they don’t issue memos to let others know it is okay to invest again. But from that point, in fits and starts, the market recovered. Eventually, the economy recovered as well.
The stock market hit its recent low on June 17th with the Dow dipping below 30,000 and the S&P 500 reaching 3,636. Since then, stocks have staged a significant rebound despite negative sentiment in the business and investing communities. At recent quotes, the Dow and S&P have risen 13% and 18%, respectively, from their June lows but remain 8% and 11% below their all-time highs. The tech-heavy NASDAQ, once down 35%, has rebounded 24% but is still down 19% from its high.
The $64,000 question is, “Was this the bottom?” The two-cent answer is, “We don’t know.” It is unknowable. But we will acknowledge it is an encouraging sign that markets have retraced about half their declines.
One difference between the current situation and recent bear market bottoms is that the Federal Reserve is committed to further interest rate hikes while past bottoms have occurred during periods of falling interest rates. This is significant because interest rates help steer the economy, but with a lag. The market is a discounting mechanism that anticipates changes by six to nine months, but it seems logical to us that we should be at least that far away from cuts in interest rates. However, some market observers believe that could happen early next year as the Fed switches from fighting inflation to reinvigorating the economy. Fed governors are considering smaller rate hikes to avoid tightening but seem more inclined to eventually pause rate hikes than to reverse course and cut rates.
At this point it isn’t even conclusive the U.S. economy is in recession except by the textbook definition of two consecutive quarters of negative GDP growth which was reached in the second quarter. Consumer spending grew in those two quarters, but the second quarter was slower than the first, which was slower than the fourth quarter of 2021. It feels like the economy is losing steam.
But a recession is not so simple to call. The official determination is made by the Business Cycle Dating Committee of the National Bureau of Economic Research. It takes so long to make a determination that the recession is frequently over before the NBER commits to its starting date.
A recession is a broad-based decline in economic activity, typically thought of as a widespread fall in output and increasing unemployment. You know a recession when you see one.
The challenge in 2022 is that unemployment remains at a 50-year low. The number of people with jobs continues to grow, but even this is misleading. The U.S. economy lost 23 million jobs in about two months after the pandemic began. Even two years later there are half a million fewer people working. Yet, GDP is clearly bigger than early 2020. Companies are straining to keep up, which partially explains elevated inflation. Even though many businesses are experiencing slowing demand, most remain understaffed and need to continue hiring.
After the Great Recession ended in 2009, we experienced a “jobless recovery” where unemployment remained stubbornly high even as GDP recovered. In 2022, we might be experiencing a “jobfull recession,” where employment grows even as output falls. This is uncharted territory.
Economic growth appears to be slowing across the globe, even in China. Chinese GDP grew slightly in the second quarter, but painfully slow by its standards due to localized shutdowns in an effort to eliminate Covid. But the rebound in July was surprisingly slow even as Covid restrictions were relaxed. The underlying problems are slowing population growth and a potential collapse in its mammoth property sector. The latter is reminiscent of the U.S. real estate market in 2008-2009. In both cases, rampant real estate speculation led to excesses. China sought to clamp down on speculative investing but with property values plummeting many homebuyers are declining to pay for their unbuilt homes. Thankfully for the U.S., we sell little to China and therefore have little to lose.
That isn’t the case for Europe which counts China as a major buyer of European exports. Even worse, Europe is dependent on energy imports including from Russia. Rising energy prices have led to worse inflation than in the U.S. Yet, the European Central Bank was months behind the Federal Reserve in raising interest rates to combat inflation.
Second quarter GDP grew in the Eurozone, but the outlook isn’t encouraging due to skyrocketing energy costs. Sitting just outside the Eurozone, the UK’s outlook is even worse. The Bank of England says the UK will go into a recession in the fourth quarter and not emerge until early 2024.
U.S. indicators clearly measure a slowdown, bordering on a recession. Consumer spending appears to be decelerating and companies are responding by cutting inventories, reducing discretionary spending, and considering selective layoffs. In July, the Fed raised its Federal Funds rate by 0.75% to a range of 2.25%-2.50%, its fourth consecutive rate hike. It is widely believed there will be further rate hikes at least through year-end, leading to a Fed Funds rate of around 3.50%. The Treasury yield curve is flat to slightly inverted, suggesting that investors believe an economic slowdown will limit future rate hikes.
If there are visible signs of a sustained economic slowdown, it is possible the Fed pauses to reassess and that is what has stock investors suddenly more optimistic. Yet, is a 3.50% rate sufficient to bring down inflation running 8.5% year over year in July? That appears unlikely to us. The Fed’s measure of “core inflation” (excluding food and energy) is rising around 5%, far ahead of its 2% objective. We would consider ourselves lucky if a 3.50% Fed Funds rate was sufficient to bring inflation to the 2% range. The risk to stock investors is that additional rate hikes may be necessary.
The constant presence of so many contradictory variables is why we don’t advocate timing the market. As best as you can, try to ignore the background noise from market pundits and market volatility. Don’t waste your energy trying to predict the unknowable. Even the once-legendary Elaine Garzarelli got it right just once – calling the 1987 crash. Focus on the few things under investors’ control: owning good companies at reasonable prices and using down markets as a time to upgrade holdings and take tax losses.
Scott D. Horsburgh, CFA