There is a lot of gloom and doom seeping into investor psychology at the moment. While much of that anxiety is well founded, some is grounded in hyperbole. Navigating through so many data points, from war to inflation, can really shake any sound investment plan, so it’s important to focus on what we believe are the key risk points and opportunities.
We are witnessing an epic struggle between the Federal Reserve and the US consumer. It’s a veritable game of chicken with the Fed trying to rein in inflation while full employment, supply chain issues, & robust spending continue to feed the price spiral. History tells us that the Fed always wins this battle. The question every market prognosticator is trying to answer is what level of interest rates are enough to choke off demand. Clearly, we are getting close to that level after three historic 75 basis point hikes. Unfortunately, real rates are still negative which means there needs to be a significant reduction in inflation or we face continued rate hikes. On the inflation front, we are witnessing some green shoots with lower commodity prices, but we have a long way to go given other major inputs like owner equivalent rent which represents 40% of core CPI. National median rent hit an all-time high as recently as August, up 12.3% from a year ago. Without any relief there, core CPI should stay elevated and, thus, a hawkish Fed.
The market interpretation of this conundrum has been as expected. While earnings have held up this year, stocks have sold off significantly. The most likely scenario is we encounter a mild recession in the beginning of next year which will lead to a deceleration in earnings. In addition, short term bonds are looking like a significant challenger to stocks. What we are trying to gauge is how much of this risk is already priced into the equity markets. The S & P 500 is currently off more than 25% this year and we are about 4-7 months into this bear market. While it can be dangerous to assume historic patterns when trying to project market moves because “it’s different every time”, history does repeat itself. With that in mind, the average bear market associated with a recession has lasted 9 months with an average equity drawdown of 35%. So, we could be 3 months and 10% away from the bottom. This last leg down is typically the most painful and where the biggest mistakes are made.
Our investment committee is focusing on the opportunities that will be presenting themselves as this bear market drop reaches a crescendo. The overall market is at best fairly valued right now at 16.8 times earnings, which reinforces the idea of further downside. However, there are pockets of real value showing up within individual names, sectors, as well as asset classes. Non-US equities look particularly cheap at 12 times earnings but could be a value trap. Short term treasuries and investment grade bonds, as mentioned, are providing yields comparable to expected future equity returns and technology and mid cap growth are reaching potentially oversold levels, having dropped over 35% this year. In addition, with about $5 trillion dollars on the sideline, a change in sentiment
could support a powerful rally in equity markets. Keep in mind bad news could be good news at this point with the market hoping a significant slowdown in the economy will force a Fed pause or pivot.
On the economic front, given full employment and the current trend of employers retaining their skilled workers, we do not expect a deep recession as our economy recovers from supply chain issues, not lack of demand. Even so, short maturity bonds are becoming more compelling as a safe harbor during this Fed tightening phase. Years of underinvestment in both single family and multifamily units are supportive of prices and additional inventory, although rates of growth in many markets are declining with rising mortgage rates. Carbon and renewable energy continue to require investment, along with modernization of the electric grid. Catching up on travel and entertainment after years of isolation is taking spending from goods purchases. Defense spending should remain elevated for years as NATO resupplies in the face of geo political struggles. Consumer staples and healthcare spending should be least impacted by a Fed induced slowdown. Please reach out to us directly with any questions or concerns.
Ned Abbe
Jess Ellington
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