What’s Next for Markets?

May 2023

This year has been strange thus far.  Unlike other years we’ve experienced, it doesn’t feel like the S&P 500 Index (domestic stocks) is up 8.3%, the MSCI ACWI ex USA IMI6 Index (foreign stocks) is up 8.7%, and the Bloomberg Barclays U.S. Aggregate Bond Index is up 3.5%.  Yet, when I look at my globally allocated portfolio, it’s having a reasonably good year.

So why the odd feeling?  It has to do with all the uncertainty surrounding the economy, inflation, bank closures, and Fed policy.  On the recession alone, there have been about 224 million Google search results on it this year and about 681 million search results on inflation, so that ought to tell us what people are thinking about these days.

The specter of still-too-high inflation resulting in the 10th consecutive Fed rate hike last week, has investors concerned that the Fed has pushed rates up so high they will finally tip the economy over the edge.  I’ve never seen a time when so many market participants anticipate an economic recession.  As a result, a black cloud hangs over markets, despite most asset classes being up this year.

As long-term investors, we shouldn’t get too caught up in the macroeconomics and let any Fed decision dictate a prudent investment strategy.  Whether the Fed is raising, lowering, or keeping rates steady is unimportant to long-term investing.  After all, financial markets want a growing economy, jobs, corporate profits, and stable prices.  We’ve experienced this in the U.S. for the better part of 100+ years, with a lot of uncertainty in between.  And stock and bond markets performed well.

So, as I look toward the summer, markets want to see clarity on the following issues:

Inflation.  The Fed has routinely stated its goal is to bring inflation down to its target level of 2.00% at each meeting.  Financial markets believe them and anticipate lower inflation as early as next year.  However, if inflation doesn’t fall to acceptable levels, it could result in continued volatility and uncertainty concerning Fed rate policy.

Economy.  Most firms our team has talked to believe we are in a recession or will officially enter one later this year.  However, imagining a recession after April’s employment report (253,000 new jobs) seems odd.  There is a slowdown in housing activity and other parts of the economy, and consumers, while still spending, are sour on the future.  Despite the headlines, there is no guarantee we will enter or avoid one.  By historical measure, stocks tend to perform the worst at least three months before an official announcement of a recession, but then perform exceptionally well exiting a recession.

The official definition of a recession seems to change each year, so some industries, like real estate, are struggling due to higher mortgage rates and might already be in recession.  But, as President Reagan once said, most economists had predicted ten out of the last five recessions!  The lesson:  beware the prognosticators!

Debt ceiling.  Washington, DC, needs to resolve the debt ceiling issue sooner rather than later.  The closer we get to June 1, when the government runs out of money, the more concerns will elevate.  If the government can’t issue new debt to pay expenses, we’ll experience a technical default and possible credit rating downgrades, increasing government borrowing costs.  There will be a significant financial hardship if this drags out too long.  They will resolve the issue, but the political posturing irritates people and markets.

Corporate profits.  If history is any guide, corporate profits tend to drop about 20% during recessions While we haven’t seen profits decline that much, they have declined from last year.  Moreover, with unemployment at all-time lows (3.4% unemployment rate), and people continuing to spend, it seems difficult to imagine corporate profits falling that much soon.

Final Thoughts

If you’ve been investing long enough, you know that building and managing a globally diversified portfolio means you have to invest during times of uncertainty.  Some of the best market gains occur during times of doubt, fear, and recessions.  Intense fear causes investors to panic and sell, which creates buying opportunities.  Market volatility and temporary downturns are great rebalancing opportunities to realign your portfolio to your proper allocation.

But we also know that none of the above challenges are new.  We’ve experienced them before and watched markets and portfolios reach new highs, but the only way to experience it is if investors remain calm and fully invested.

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