Market Commentary - Q3 2022

Equity and bond markets were hammered in the second quarter as inflation soared and the Federal Reserve began a cycle of significant rate hikes. This put a couple of worrisome questions into the spotlight: Is the risk of a recession growing? How can investors prepare for upcoming volatility?

Paying the Piper

The government’s massive fiscal stimulus response to the COVID pandemic, some $5 trillion over the 12-month period ending March 2021, along with the Fed’s aggressive series of rate cuts in the first quarter of 2020, unleashed a stampede into risk assets, ranging from stocks to high yield bonds.

Now, the economic pendulum is swinging back. Near-zero rates distorted the cost of capital and fiscal interventions prompted excess consumer demand. This combination of events has sparked today’s soaring inflation – creating a monetary “beast” that the Fed’s recent and abrupt about-face hopes to tame.

• We view the unwinding of fiscal injections and monetary stimulus as a corrective change from the “sugar high” of pandemic-era support which led to unsustainable consumer demand, corporate profits and risk asset returns. Over the last two years, the Fed has acted as both referee and player but now resumes its traditional role as market referee.
• The inflation genie released from its bottle shows few signs of being tamed. Supply chain disruptions, shipping challenges and labor shortages continue to fuel price hikes.
• While there are signs U.S. consumers are tightening their wallets after a spending spree, the war in Ukraine as well as Chinese plant closures continue to boost commodity and consumer durable prices.

Recession Risk

During Fed Chairman Powell’s June meeting with the Senate Banking Committee, he reconfirmed the Fed’s “strong commitment” to bring inflation down from 40-year highs.

But the prospects for a soft landing—taming inflation without dragging the economy into recession—are becoming increasingly unlikely. According to Powell, such an economic outcome would be “very challenging” and a recession, he stated, is “a possibility”.

• Can the global economy withstand a cycle of significant rate hikes? According to the World Bank, prospects for a soft landing are gloomy. Global Gross Domestic Product (GDP) growth, the Bank expects, will remain below 3 percent for the next two years. The risk of stagflation is “hammering growth,” wrote President David Malpass. “For many countries, recession will be hard to avoid.”
• More negative news came in the form of June’s preliminary S&P Global Composite Purchasing Managers' Index reading of 51.2, down from 53.6 in May. This is the lowest level since January, when pandemic-related disruptions slowed growth, and the second-weakest reading since the height of the pandemic in mid-2020.
• Consumer sentiment is also declining, falling below the recession of 2008/2009's low, putting additional pressure on the prospects for U.S. GDP growth due to an impending negative wealth effect.

Looking Ahead

We believe a mild, “garden variety” recession is rapidly becoming a base case scenario for the U.S. economy with the most significant impact focused on consumer credit’s support of the auto and home sectors.

One encouraging difference between today and the recession of 2008/2009 is that the U.S. banking system is less vulnerable to some of the forces, including bond derivatives and subprime loans, that led to banking stresses in the “Great Recession”. Also, this time around, contagion from risk asset class bubbles is less likely: bitcoin and NFT troubles are unlikely to materially impact traditional equities and bonds.

• Investors should prepare for a U.S. recession and a bear equity market. How long the pain will last is unclear, but the average recession since 1926 lasted 22 months and the average equity bear market lasted 15 months for a cumulative loss of 38 percent.
• Because the equity market is, in our view, returning to a reality that rewards durable corporate earnings and growth at a reasonable price, “old school” stock- and bond-level research will become critical. We believe that active managers will outperform index funds as yesterday’s mega-cap technology stocks rotate out of favor. In a “risk-off” environment, investors may also become opportunistic as bargains should become available.
• Investors should be leery of responding to market events from an emotional basis. While equity and bond bear markets can be wrenching, and there may be significant declines going forward, note that the average bull market since 1926 lasted nearly seven years and returned a cumulative 339 percent. By keeping their investment time horizon in mind and working with their financial advisor, investors can build resilient all-weather portfolios able to withstand whatever the future brings.

©2022 MUFG Union Bank, N.A. All rights reserved. Member FDIC.  Union Bank is a registered trademark and brand name of MUFG Union Bank, N.A. unionbank.com

Related Articles

Market Commentary - Q2 2022

Russia’s Invasion of Ukraine: Market and Economic Implications

Market Commentary - Q1 2022

Market Commentary - Q4 2021

Real Estate Outlook: West Coast Recovery Underway

Market Commentary - Q3 2021

Market Commentary - Q2 2021