What’s Up With Current Market Volatility?

May 2, 2022 10:38 am

Betsey A. Purinton, CFP®

Managing Partner & Co-CIO

We are amid one of those nasty pullbacks, and this time there is no place for an investor to hide. April ended with the S&P 500 and the All World Country Index Ex US down 13% year to date, while the US aggregate bond index has fallen 9%. Commodities have been a bright spot, but a diversified portfolio can only hold so many shares of this volatile asset class. Market performance has left many investors praying for a turnaround soon before more damage can be done.

Let’s remember that markets correct for a variety of reasons, with recovery rates varying tremendously based on the cause of any downturn. For example, it took 15 years for the Nasdaq to recoup losses after the tech bubble burst in 2000 and only five months for the S&P 500 to rebound after the 2020 pandemic pullback, thanks to quick action on the part of the Federal Reserve. The comeback for the S&P 500 after the 2008 credit crisis was seven years. And while recovery times following recessions vary depending on the severity of the recession, the average has been calculated at around 2 years. When we are not experiencing a market bubble, a credit crisis, a recession or a black swan event, markets can rise and fall within a matter of days or weeks, depending on the headline news. This is why it is so hard to “time” the markets.

So, why are markets struggling now?

The key factor is inflation – or more specifically the cure for inflation. (There are other concerns holding back the markets, but I will focus on the Federal Reserve’s response to inflation.) The Federal Reserve oversees control of inflation. The key tools the Fed uses are raising interest rates to curtail demand and paring back government debt which reduces available money to spend and invest.

Markets fear that the Fed will need to act too aggressively to combat inflation, raising interest rates significantly and driving the economy into a recession. The Fed’s inflation fighting actions are called tightening. The good news is that when a recession does happen following Fed tightening, it usually doesn’t occur for several years. That is because when tightening starts, the economy is usually quite strong and Federal Reserve actions take a while to work their way through the economy.

You might have noticed this past week that first quarter Gross Domestic Product (GDP) figures were released. As the number was negative, rumors of a “recession” immediately popped up. There is a general impression that the definition of a recession is two back-to-back negative quarters of GDP growth. While two quarters of contraction are usually necessary, the definition is much broader than GDP. The National Bureau of Economic Research is charged with reviewing a large range of data, including employment, income, manufacturing and wholesale/retail sales, to determine when a recession begins and when it ends. Since the labor market is the strongest in around 40 years, incomes are rising at a steady clip, manufacturing numbers are up, and sales are as high as supply chains allow, it is highly unlikely that we are entering a recession at this moment.  Q1 GDP actually fell due to an issue with trade, whereby imports exceeded exports due to supply chain logistics. That issue will hopefully prove temporary.

Alan Blinder, former Vice Chair of the Federal Reserve, wrote an op-ed in the Wall Street Journal last week in which he argued that the next recession is likely to be a mild one, given that this round of inflation is young, the Federal Reserve has the tools and the desire navigate a soft landing, and the $2.5 trillion in US consumer savings will help cushion the blow of higher interest rates.

So, if a recession is not likely for several years and, if it does occur, it could turn out to be mild, why are the markets so pessimistic?

In part it is that the markets entered the year overvalued by most estimations. The three-year annualized S&P 500 return from 2019- 2021 was 24%, much higher than the long-term average 10.5% annual rate of return since 1920. Since markets tend to revert to their averages over time, markets were primed to pullback in 2022 if given the opportunity.

In addition, the current decline of the stock market is hardly unusual. Since 1945 the average drawdown in a midterm election year has been 17-19%. With the S&P down 13% YTD, this pullback is well within the norms. Historically, markets find a bottom during midterm election years sometime before the fall, at which point trends show a recovery into the end of the year. It could be that markets are simply following an historical pattern.

However, the most likely reason is that the Federal Reserve must navigate a very narrow path to reduce inflation successfully without dramatically impacting the economy. A successful soft landing is anything but assured. If the Federal Reserve moves too aggressively, economic growth could falter, and the economy could be thrown into a recession that is none too mild. However, if the Fed moves too slowly, inflation could continue to climb, requiring even more aggressive Fed action in the future, and thus continued misery at the pump and grocery store. In the Goldilocks scenario, the Fed reduces economic growth just enough to quell high inflation without causing jobs, income, production and spending to meaningfully contract. The uncertainty of possible outcomes is what keeps the markets guessing and gyrating.

Until the current unknowns are known, markets will likely continue to vacillate between positive and negative returns. By the time investors feel confident in where the economy could land, they will likely already be looking towards the next recovery and uptrend. That is how business cycles and corresponding market movements often unfold.

 

Betsey A. Purinton, CFP® is Managing Partner and Co-Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com.

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.