The market recovery to start the second half of the year stalled in August. U.S. stocks fell 3.7% and U.S. bonds declined 3% during the month, renewing fears of a more impactful bear market.
To a significant degree, we have re-entered a phase where good news is bad news and bad news is good news as investors are hyper-focused on what the Fed may do to combat inflation.
Feds’ Approach to Inflation
The most significant moment of August was Fed Chair Jerome Powell’s speech in Jackson Hole, where he put to rest any idea that the central bank would begin “pivoting” to a more accommodative stance in the near term. Instead, focus remains on slowing the economy to address inflation. Another 0.75% rate hike in September is now widely anticipated. It is an important factor that shorter-term bond prices already reflect expected increases. Despite Powell’s “higher, longer” rhetoric, we would not be surprised if short-term bonds post gains in the face of additional rake hikes.
Although higher interest rates and a flat or modestly inverted yield curve are creating anxiety, a soft landing for the economy remains a strong possibility. Earnings growth has slowed but remains positive, and all ten economic sectors posted revenue growth in Q2, according to FactSet. The most recent jobs report in early September highlighted strong job creation, but also a solid increase in the labor participation rate. This demonstrated robust activity while also lifting the official unemployment rate to 3.7%, which could ease some wage pressure.
There are countless opinions on where inflation, interest rates and the economy are headed. Even if those were known, it would be difficult to predict equity markets. We see current valuations balanced relative to risks in the U.S., and attractive overseas. However, in deep bear markets, stocks can become irrationally cheap, featuring volatility well beyond what we have experienced recently. There is no way to know if this bear will feature a climactic ending or simply fade away. We advise preparation for both and taking steps to avoid reacting emotionally. This bear is still relatively young and shallow, but it is maturing. That means the birth of a new bull market is getting closer.