- A bear market hit U.S. stocks (a decline of 20% or more) in 2022.
- Markets rebounded shortly thereafter, regaining some of the ground lost during the downturn.
- Yet markets remain volatile in light of recent Federal Reserve indications it will maintain an aggressive approach to fighting high inflation.
U.S. stocks, as measured by the benchmark S&P 500 index, officially fell into “bear market” territory in June 2022. This represents a decline that exceeds 20% of the peak value of the index. The technology-heavy NASDAQ Composite Index (which includes about 3,000 common equities) and the Russell 2000 Index of small-cap stocks both dropped into bear market status earlier in the year.
Stock market downturns such as these occur periodically, and for various reasons. Sometimes the changes are related to excessive market valuations after an extended bull market. In other cases, they may be due to external events which overwhelm other fundamental factors that traditionally drive stock market performance.
“The most recent downturn can be attributed to rising level of uncertainty for investors,” says Rob Haworth, senior investment strategy director at U.S. Bank. Three key events contributed to the environment, including persistently high inflation, a dramatic change in monetary policy by the Federal Reserve and the economic fallout from Russia’s invasion of Ukraine.
Stocks rebounded after reaching their June lows but retreated once again as investor fears of a recession rose.
Tracking previous market declines
Explanations for most serious market downturns are typically easier to come by after the fact. Consider some recent examples.
In early 2000, an extended bear market began that persisted until early 2003, on the heels of a long-lasting bull market. The most notable driver of this significant setback for equity prices was the bursting of a stock market “bubble” in prices for technology stocks, particularly some early-stage dot-com companies, as investors stopped paying higher prices for companies with little to no earnings.
The 2007 to 2009 bear market was driven in large part by a collapse in home prices. Too many property owners were highly leveraged, and not capable of sustaining the mortgages they obtained. This easy credit environment created problems throughout the financial system that required significant government intervention.
In February and March 2020, investors were just beginning to come to grips with the reality of the COVID-19 pandemic. Concerns about the unknown ramifications to the economy from social distancing and travel restrictions caused investors to temporarily lose confidence in stocks. That downturn was short-lived, and those who remained invested in stocks prospered through much of 2020 and throughout 2021.
“In today’s market, we saw a massive change in sentiment,” says Haworth. The persistent nature of an elevated inflation rate appears to be a key cause of investor anxiety. Higher inflation is a result of demand for goods and services outpacing supply. Haworth notes that despite dramatic moves by the Federal Reserve (Fed) to ease economic growth, higher inflation endures. “If inflation stays elevated, the Fed will have to take more aggressive action to try to slow the economy,” says Haworth. “The market setbacks in late August and September reflect that the Fed may have to raise the fed funds rate above 4% and hold it there well into 2023.”
The Fed’s focus on slower economic growth
The economy as measured by Gross Domestic Product (GDP) grew 5.7% in 2021 (the fastest annual rate of growth since 1984). The Fed’s shift in monetary policy is intended to slow the economy as a way to temper the inflation threat, but without pushing the nation into a recession. An economic slowdown occurred in the first half of 2022. Annualized GDP declined by -1.6% in the first quarter, and -0.6% in the second quarter of the year.1 Despite the negative reading and the Fed’s efforts to temper economic growth, job growth was impressive through the first eight months of 2022, as non-farm payrolls grew by 3.5 million jobs.
“Despite two quarters of negative GDP growth, there are no signs that the labor market is under duress,” says Haworth. “GDP data appears to be either narrowly positive or narrowly negative, so it could be nudged in either direction.” The primary threat to the economy may be the Fed’s desire to defeat the inflation threat. Despite raising the Fed Funds rate by 2.25% to 2.5% so far in 2022, inflation numbers remain high. Through August, the Consumer Price Index, the benchmark measure for broad inflation, rose 8.3% over the previous 12 months. While lower than the peak change of 9.1% reached in June, markets appeared concerned the decline wasn’t more significant. While Haworth expects significantly more Fed rate hike activity, it’s notable that economic growth is not collapsing, and the labor market remains strong.
Stocks remain susceptible
Challenges such as Fed money tightening and higher inflation have kept the stock market in a volatile state for most of 2022. An additional concern going forward will be market fundamentals, such as corporate revenue and earnings. “A major question now is whether higher wage costs are hurting the bottom line for companies,” says Haworth. “Companies have been able to maintain earnings levels to date because they could push through price increases,” says Haworth. “Can they continue to do that? It will tell us a lot about how earnings hold up through the year.”
“Keep in mind that we’re likely to experience market ups and downs regardless, and over time, markets have shown an ability to recover.”
– Rob Haworth, senior investment strategist, U.S. Bank Wealth Management
Eric Freedman, chief investment officer at U.S. Bank, says it’s important to maintain an appropriate perspective about the environment. He cautions that markets are likely to continue to be volatile. Nevertheless, he urges investors to maintain a long-term perspective. “Timing the markets and trying to be precise on when to be in and when to be out is challenging,” says Freedman. “Markets will do things at the exact opposite time you expect them to.”
Key factors to watch
What are the critical factors at play that could impact the timing of a turnaround in the markets?
- Inflation and Fed policy responses to it. “Inflation concerns remain near the top of the list,” says Freedman. “Inflation is proving more persistent than initially anticipated.” Notably, Fed Chairman Jerome Powell has proclaimed that “Reducing inflation is likely to require a sustained period of below-trend (economic) growth.”2 That indicates the Fed’s determination to take significant steps to slow the economy to bring inflation closer to its 2% target range. Freedman believes inflation could subside in the months to come, though a range of variables may impact the trend. Along with significant increases in the fed funds rate so far this year, the Fed ended its monthly purchases of $120 billion in Treasury and mortgage-backed bonds that began in early 2020. The strategy that was designed to help maintain liquidity in the market and keep interest rates lower. It is now scaling back its existing bond holdings. The Fed’s ongoing monetary tightening puts upward pressure on yields for Treasury bonds and mortgage-backed securities. In fact, yields on the 10-year U.S. Treasury reached their highest point in 11 years in mid-June, near 3.5%, then dropped below 3.0% but began to rise again in August. “The economic data we’ve seen over the summer, including the strong jobs reports, indicate a material risk that the Fed continues to raise rates more significantly,” says Tom Hainlin, national investment strategist, U.S. Bank. “If this slows the economy further, dampening corporate profits, investors may not be willing to pay such high prices for stocks.” He notes that the Fed is trying to thread a needle by slowing the economy without tipping it into a recession. “But at this point, even a modest recession may be considered a success by the Fed,” says Hainlin.
- Consumer spending. Consumer spending is a major driver of economic growth. “Consumer balance sheets remain solid,” says Haworth. “Asset wealth declined a bit in recent months due to the stock market decline, but credit balances remain low relative to incomes,” says Haworth. “In a normal recessionary cycle, we’d see the system working off excess borrowing by consumers, but since that issue does not confront the Fed today, it seems more likely that any economic contraction will be moderate in nature.”
- COVID-19. The virus that was so disruptive in recent years has become more part of our everyday lives, but not yet a thing of the past. “We reopened more, with people heading back to offices and more activity occurring, which is supportive of economic growth,” says Haworth. Yet COVID remains a concern, particularly as we move closer to the winter months.
- The impact of the Russia-Ukraine war. One of the most unpredictable variables is the war in Eastern Europe with economic sanctions acting as a primary weapon used by western nations opposed to Russia’s actions, it remains to be seen what the long-term global impact could be. Higher commodity prices are another consequence of the war, which also could dampen global economic growth. Much may depend on how long hostilities persist and whether the conflict spreads to other countries. The U.S. economy seems less susceptible to negative ramifications than is the case for Europe, where many countries are highly dependent on Russian energy resources.
Keep a proper perspective
Frequent market corrections are a normal event. “Keep in mind that we’re likely to experience market ups and downs regardless, and over time, markets have shown an ability to recover,” says Haworth. Market volatility can be expected to persist given the uncertainty about the direction of inflation, the extent of Fed interest rate hikes, the pace of earnings growth and implications of the ongoing Russia-Ukraine conflict, among other issues. “While we may see a more favorable environment develop down the road, the market still faces many challenges given the current economic underpinnings,” says Haworth.
Freedman emphasizes that having a plan in place that helps inform your investment decision-making is critical, particularly in times like these. “That’s the foundation of investing,” says Freedman.
Check in with your wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your long-term financial goals.
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