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Chief Investment Officer Jon Maier and Head of Thematic Solutions Scott Helfstein offer their views on the current investment landscape during an extremely challenging year for investors. Market conditions appear to be developing tougher by the day with inflation remaining high and persistent, the Federal Reserve (Fed) looking more hawkish, and the approaching midterm elections, among other issues. Jon and Scott have extensive experience in volatile markets, and they both agree: 2022 is distinct, but as in every downturn, cooler heads are likely to prevail.
Is this time different?
Jon Maier: Absolutely. But every cycle is different, whether difficult or not. In my experience, different time periods can rhyme with each other, but no time period is exactly the same, which can actually provide investors with some comfort when looking for new opportunities. What remains the same is that investing is not easy for anyone, regardless of the market environment. Investors get information, take a bit of history, and weave together what they think is a cohesive investment thesis. But then, completely unpredictable exogenous factors can derail the thesis.
Scott Helstein: Each cycle has both unique and familiar elements. For example, systematic failures in the banking sector led to the global financial crisis of 2008 and bad debt write-offs began in 2007. Excess liquidity and exuberant valuations caused the dot-com crash in 2001. It generally makes sense to pay attention to liquidity, valuation and lending. What makes this downturn unique is that it is the first crisis since the 1970s where inflation is a significant factor. Inflation and Fed tightening in the late 1970s and early 1980s led to a painful recession, but also paved the way for continued expansion with real GDP growing 5% from 1982 to 1987.1
When will inflation go down? How to think about asset allocation with high inflation?
Mayer: Inflation is difficult. No one has succeeded yet, certainly not the Fed. We know credit expansion is inflationary, but pandemic-induced inflation is a completely different dynamic, especially intertwined with a war affecting energy markets. Expected inflation indicators have weakened considerably, even if the published figures are different. But real estate inflation is tenacious. High rents are a tough cycle to break when mortgage rates are at 7% because they put homebuyers in the rental market. The only tool the Fed has is to tighten, but how far the Fed can push is a question.
Helfstein: There are signs that producer prices have started to slow, and there are even hints of a slowdown in consumer inflation. That said, there’s nothing magical about 2% inflation, except that it’s the Fed’s target, which was set in 2012. 2% inflation is historically quite low and probably reflects the deflation that was imported by the opening up and industrialization of China in the late 1980s. The Fed keeps reiterating 2%, but it has also spent months declaring that inflation was ‘transitory’ and expectations were ‘anchored’.2 One solution to Fed tightening could be to raise the official inflation target to 4%. After a short period of adjustment, such a measure could help the economy regain strength.
Has the stock market already priced in a recession? Is it time to buy stocks?
Helfstein: We all wish we had a crystal ball to call market lows, especially this one. We know that stocks have revalued. The S&P 500 forward P/E has fallen from 23x to 16x this year.3 The decline in Russell Growth was more pronounced, dropping from 34x to 22x.4 When markets are selling 25% or more, one-year returns are usually quite good.5 Some assets appear to be on sale, but the future may not look like the past as fundamental shifts in areas such as inflation or globalization could signal a regime shift. Caution is advised when looking for opportunities. Nominal assets, stocks and commodities are potentially attractive, depending on time horizon and risk tolerance.
Mayer: The September Consumer Price Index (CPI) came out hotter than expected. Services inflation drove the print as goods inflation held steady, not the best news for short-term market performance. For investors, there is a certain behavioral psychology at play in conditions like these, as buying in a bear market is unnatural. Conversely, when markets go up, investors’ endorphins kick in and they become aggressive because they don’t want to miss out. In a downturn, it’s critical to remember that valuation matters over the long term, as it explains much of the S&P 500’s subsequent 10-year returns. As in other downturns, this bear market can be an attractive opportunity for long-term investors.
In conversations with clients, we focus more on short-term rates with the 2-year around 4%. Does this make short-term debt more attractive compared to equities?
Helfstein: Investing in a 4% bond with 8.3% inflation means the investor only lost 4.3% on the investment for the year, which is not a real rate of return attractive. The expression real rate is important. According to behavioral economics, investors tend to think about nominal returns rather than factoring in inflation and thinking on a real basis. The practical benefit of adding a 2-year bond at 4% is that the asset reduces portfolio volatility. For some investors, this is an attractive compromise. For others, the idea of locking in a negative real return may not be so appealing.
Mayer: The answer really depends on the time horizon of the investor. If inflation is annualized at more than 8% and the investor earns 4% before taxes, he loses money. But if they think there might be more room on the downside but aren’t sure, a barbell approach to short-dated, relatively high-yielding Treasuries alongside companies or sectors with solid fundamentals can be effective.
What impact will the US midterm elections have on the market?
Mayer: History suggests no impact as the result will likely be a divided government. Investors generally like a divided government because it reduces the likelihood of big spending programs and changes in the regulatory environment and tax policy. But the government still has to function. Given the divisions between the parties, the simplest things that should be done, whether raising debt ceilings or passing budgets, can be delayed or contention filled. Markets are unlikely to react well to such scenarios.
Helfstein: Traditionally, a divided government is favorable to the market. One risk to consider is that markets have become accustomed to stimulus since 2008 and a divided government would likely reduce fiscal flow. As midterm elections loom to split the government, polls have been less than accurate in recent elections and burning issues could mobilize voters on both sides. The impact of this election on the markets may be less important than the information it provides for future political expectations. Paying attention to races where candidates farther along the political spectrum, both left and right, are running against centrists might make sense. These races can provide a better diagnosis of the electorate in the future.
FOOTNOTES
1. Bloomberg, LP (nd). [Data set]. Data as of October 13, 2022 and retrieved October 13, 2022.
2. Rugaber, C. (2021, June 22). Associated Press. The Fed’s Powell said temporary high inflation “will come down.” Fed’s Powell says high inflation is temporary and will ‘come down’
3. Global X analysis with information from: Bloomberg LP (nd) [Data set]. Accessed October 13, 2022.
4. Same.
5. Same.
GLOSSARY
Consumer Price Inflation (CPI): The CPI measures the average change in prices that consumers pay for a defined basket of goods and services.
S&P 500 Total Return Index: The index includes 500 leading US companies and covers approximately 80% of available market capitalization.
Investing involves risk, including possible loss of principal. Diversification does not assure a profit or guarantee against a loss.
This material represents an assessment of the market environment at a specific time and is not intended to be a prediction of future events or a guarantee of future results. This information is not intended to be individual or personalized investment or tax advice and should not be used for commercial purposes. Please consult a financial or tax advisor for more information regarding your investment and/or tax situation.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.
