Burt White, Chief Strategy Officer
So far, 2022 is off to one of the worst ever starts of a year for stock returns. And the reasons are numerous and front of mind for us all: an unexpected war in Ukraine, the lingering impacts of COVID-19, the highest inflation rates in 40 years and the prospects for a contentious midterm election right around the corner.
Given all that uncertainty, equity prices in 2022 have seen greater levels of volatility and have dropped into correction territory for the first time since the initial onset of the COVID-19 pandemic in early 2020.
However, this rising collection of market uncertainty comes at a stark contrast to the continued relative strength of the U.S. economy, which remains buoyed by strong consumer spending, the healthiest job market in decades and increased confidence for companies to invest in their business.
So why is there such a difference between the good news about the U.S. economy and the bearishness of the stock market?
The likely cause for most of this uncertainty is a result of three inflection points the market is assessing. These inflection points are raising the blood pressure of the market, but we believe they will work themselves out over the near-term. So what are these three inflection points, and how might they unfold going forward?
COVID-19 Shifts from a Pandemic to Endemic
COVID has caused an incalculable amount of destruction in the world. The loss of life, the economic impact on businesses, the canceled opportunities and memories with friends and family – it’s been a tough two years.
But what we are likely going through right now is the inflection point of COVID going from a pandemic – widespread, uncontrolled infectious disease – to an endemic, where the virus may remain a significant health threat but becomes more seasonal and predictable, similar to other communicable diseases.
The reopening of the world post-pandemic is one of the major reasons inflation is surging. The combination of businesses trying to get back up to speed after being shuttered during the early portions of the pandemic mixed with the pent-up demand of American consumers ready to spend on new homes, cars and travel has created an imbalance in supply and demand that is putting pressure on prices for everything from eggs to airfare to housing. And the result is the highest inflation rates in four decades.
But much of this inflationary pressure appears to be transitory – the mix of pent-up demand and a business environment still reopening – and it should begin to sort itself out over time as businesses adjust to the endemic phase of COVID.
Policies Shift from a Tailwind to a Headwind
Another inflection point is the shift from government aid to a hawkish and tightening fiscal policy. Fiscal spending, which provided trillions in aid, has come to an end. And now, monetary policy from the Federal Reserve – which had long kept interest rates near zero – is reacting to tighter financial conditions.
The Fed has already raised rates twice this cycle, including a rare 50 basis-point increase for the first time since May 2000. Rates have been near zero since 2008 – outside of a quick rise in 2017-19 – though historically that’s far from the norm.
It’s this shift from accommodating fiscal policies to more restrictive ones that has the market feeling uncertain. But these steps are necessary to rein in inflation. Rates that were too low and deficit spending that was too high contributed to the current inflationary environment. As this shift plays out, markets should become more comfortable with the revised policy and experience lower volatility. And while individuals may bet more money from interest under this shift, corporations likely will not, which should slow down the economy.
The Four-Year Presidential Cycle Hits its Mid-Point
Political ads are dominating the airwaves in states holding primaries, as is rhetoric from both sides of the aisle that things are bad and need changing. Expect even more political adds in October and November. These ads bring more than just ramped-up political tensions – this inflection point also drives uncertainty in markets regarding the future path of policy and the makeup of decision-makers. As a result, the second year of the four-year presidential cycle is usually the most volatile as it leads up to the midterm elections.
The good news is that after this midterm election inflection point, history shows that some of the best periods of equity returns often occur. In fact, the best three quarters on average of the four-year presidential cycles since 1970 have materialized post-midterm elections.
Volatility is Normal and Healthy
It’s important to note that market volatility is both commonplace and healthy, especially after the greater-than-100% rally in stocks following the pandemic lows just over two years ago. And while market dislocations are never pleasant, they have rewarded patient, long-term investors with attractive entry points. In fact, of the 33 market corrections since 1980, 90% of them saw gains over the following year – averaging around 25%.
Our view remains that we are near or even past the peak of inflation, and with a limited but swift series interest rate hikes, the Fed can curb inflation further while creating a soft landing for the economy. Furthermore, as these shifts inflection points unfold during the rest of 2022, we expect equity markets to stabilize and reverse course.
Burt White is not affiliated or registered with Cetera Advisor Networks LLC. Any information provided by Burt White is in no way related to Cetera Advisor Networks LLC or its registered representatives.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated herein are not necessarily the opinion of any other named entity. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.
The 3 Inflection Points Behind the Stock Market’s Dip is written by Burt White for www.pestaandpesta.com