Economic growth is moderating
Excessive pandemic-related stimulus coupled with labor and supply chain shortages has pushed up prices of goods, services, and housing in many markets. To mitigate inflationary pressures, central banks are raising interest rates and removing money supply. Complicating the process are the unexpected invasion of Ukraine and China’s continued rigid approach to controlling the spread of Covid-19. It remains unclear as to whether these factors will slow growth to a sustainable level or lead to a period of contraction followed by an above-average expansion.
The confluence of events impacts stock markets.
Stock markets are volatile as buyers and sellers adjust their earnings expectations as new information is disseminated. All markets are below where they started the year: down 20% for the U.S. (S&P 500 Index), down 19.6% for international developed markets (MSCI EAFE Index), and down 17.6% for the emerging equity markets. Our longstanding approach of emphasizing stocks trading at more reasonable valuations (“value stocks”) helped mitigate the recent drops. The Russell 1000 Value index was down 13.1% year-to-date compared with a much steeper drop of 28.2% for the Russell Growth Index.
Higher interest rates have a negative effect in the short-run, but positive in the long-run.
The Federal Reserve is in the process of returning short-term interest rates to more normal levels. While the stimulus of near-zero interest rates was required during the pandemic, such abnormally low rates are inflationary over time. Two-year maturity U.S. Treasury Notes yielded 0.7% at the start of the year. They yield 2.8% now. While higher yields provide more income over time, the change in rates causes existing bonds to drop in price. The broad investment grade bond market’s total return for the first half of this year was – 7.5% (Bloomberg US Aggregate Intermediate Index). Current higher yields will improve future fixed income returns.
U.S. Equity returns over the past three years are consistent with expectations.
Time horizon has always been an important factor in determining how much risk to take in the near term to achieve one’s long-term goals. Looking back over the past three years, an investment in the U.S. stock market returned 10.6% (S&P 500 Index), slightly above reasonable long-term estimates for that market. While we knew that above-average stock market returns and below-average bond market yields were likely to return to their long-term averages, no one knew when it would happen or whether the change would be gradual or swift. Financial markets are now much more attractively valued than they were at the start of this year. Unless your goals or circumstances have changed, we do not recommend a change in strategy.