No one noticed, but almost all stock and bond categories registered positive returns this past quarter.  A softening of inflationary factors – most obviously gasoline prices - has boosted investor sentiment.

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Inflation peaked last June at an annualized rate of 9.1%.  By November, that rate declined to a less awful 6.5%.

Accordingly, the Federal Reserve continues to hike short-term interest rates but at a slower pace.  Fed watchers are anticipating two or three smaller rate increases through mid-year.

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As reflected in your portfolio, Wall Street has reacted with optimism, perhaps a little too much, as the inflation saga is still playing out.  In November, Fed Chair Jerome Powell warned: “the ultimate level of interest rates will be higher than expected.” 

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Hikes are hikes, so interest-sensitive sectors like real estate, already in recession, will be particularly hard hit.  Rate-hike ripple effects will likely push unemployment to 5% this year, painful but not catastrophic.  The anticipated mild recession should dampen price hikes and wage demands.

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Econ 101 and the “punch bowl” effect.

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With its special brand of voodoo, the Fed must gauge mass psychology as it sets the cost of borrowing.  If you remember your “Econ 101,” when money is too cheap, spending accelerates while outstripping supply.  A growing expectation of inflation then becomes self-fulfilling; it compounds wage demands and price hikes.  Recessions typically achieve the reverse. 

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When easing the money supply, the Fed must choose the moment to remove the punch bowl before the party gets out of hand.  In retrospect, the Fed admits they should have tightened the money supply long ago.  Additionally, the prior Congress vastly increased money in circulation, particularly with Covid relief packages and major tax reductions.  

Mainstream prognosticators expect inflation to fall below 4% by the end of the year.

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Historical reassurances regarding recessions.

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Higher interest rates and nagging inflation will likely tip the U.S. economy into a recession in 2023, leading to a 15% to 20% drop in corporate earnings – of course, clobbering stock returns.  

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While each recession is painful in its own way, one potential bright spot is that they don’t historically last long. An analysis of 11 U.S. cycles since 1950 shows that recessions have ranged from two to 18 months, with the average lasting about 10 months.

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Furthermore, stock markets usually start to recover before a recession ends.  Stocks have already led the economy on the way down in this current cycle, with nearly all major equity markets entering bear market territory by mid-2022.  And if history is a guide, they could rebound about six months before the economy does. 

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The benefits of capturing a full market recovery can be powerful. In all cycles since 1950, bull markets had an average return of 265%, compared to a loss of 33% for bear markets. The strongest gains have often occurred immediately after a bottom. Therefore, waiting on the sidelines for an economic turnaround is not recommended.

 

Recession vs. Economic Expansion - 1950 through 2021

 

 

 

 

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Source: Capital Group et al. Past results are not predictive of results in future periods.

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