May 09, 2022
Meritage Current Market Update
We try not to overdo these special market notes, but the recent volatility and weakness in the market is clearly deserving of an update. Our intent is to provide some context to what is going on and share a few thoughts on how we all get through these truly challenging investment times.
Particularly unnerving has been the heavy pressure on stocks in an unprecedented short time frame, punctuated by sharp rallies that provide momentary but fleeting relief. None more evident than the about-face in stock prices yesterday, following the Fed’s widely expected 50 basis point rate hike and related commentary.
What has changed?
- The markets have taken a decidedly negative turn since our last correspondence at quarter-end. The late-March rally that recouped a portion of the first quarter’s decline has given way to renewed concerns about rising inflation and the increased likelihood that it is heading higher and persisting longer than previous expectations. The Fed’s strategy to contain inflation by tightening credit into an economic slowdown could lead to a recession, as it has historically in similar circumstances.
- Contributing to this dour outlook is China’s rigid lockdown policy on managing COVID risk, and the prospects of a more protracted war between Russia and Ukraine. These non-U.S. socio-economic big picture issues are keeping pricing pressure on oil, grains, and other commodities as well as disrupting supply chains in the U.S.
- So far, large cap growth stocks have borne the brunt of the overall equity market decline. The speed and magnitude of unwinding the favorable financial backdrop conducive for growth stocks has been stunning. The weakness has spread from the most egregiously valued growth names to broader growth companies including mega-caps like Amazon, Facebook, and Google.
What can we expect in the near-term?
- Volatility will likely stay elevated as we move through the next several months of rate hikes and more inflation data. Of course, investor sentiment and psychology play a large role in the daily pricing of securities, not to mention the impact of artificial intelligence driven algorithms fueling trading strategies that benefit from volatile markets.
- Fed Chair Powell’s inclination to reject a more aggressive rate hike approach was initially praised for avoiding signs of panic. The market’s subsequent decline suggests a reassessment of the strategy’s adequacy to effectively bring inflation down. It may also be a reaction to bond yields gapping higher. Either way, it is hard to attach much significance to any rally that is not accompanied by some indication that inflationary pressures are ebbing.
- The Fed has shown their hand with respect to two additional 50 basis point rate hikes in June and July, leaving the next decision point for the third week in September. By then, the Fed hopes to see evidence that inflation is slowing. Signs that auto prices have peaked and higher mortgage rates may be cooling the rise in home values provide some hope, although the market seems to be pricing in a harder economic landing.
- The pressure on growth stocks may continue if bond yields continue to move higher, even though there has already been a major reset in valuation measures. As always, there will be a point where the valuation constraint goes too far and growth stocks will reprice enough to enable good future returns again. There will always be performance cycles between the primary investment styles of Value and Growth, but it is unlikely that the environment will return to the extreme combination of zero interest rates, excess liquidity, and massive economic stimulus that favored growth stocks for most of the post-Financial Crisis timeframe.
How should we be thinking about Risk Management?
- The answer to this question varies depending on the needs and circumstances for each client. For some, the ability to put the blinders on and remain focused on the long-term enables them to maintain their investment strategy through difficult cycles. For others, they may have shorter time frames to deal with, or unforeseen expenses that must be met no matter how strongly they feel about their risk tolerance.
- On the positive side, the current economy looks healthy in the near term (strong consumer demand, robust employment, solid wage growth, and strong corporate performance), and expectations of a diminished outlook may already be discounted by the recent price drop. The market always finds a bottom well before it is visible to investors.
- Risk management is part of our daily process. We have made shifts into value from growth for many situations where growth had expanded to a significant overweight. Given our view that the financial backdrop will be more hospitable for value stocks with strong fundamentals, increasing exposure to value may still make sense in some cases.
We find ourselves saying “We will get through this” when we speak with clients. We don’t intend to be dismissive of the discomfort everyone is feeling going through this sharp decline, nor do we want to instill false hope that it all gets better immediately from here. We also know having gone through these cycles before does not make it any easier. Our primary focus continues to be on you and your individual circumstances. Every day we are committed to making the best judgments we can, using all our selection, risk management, policy determination and planning process tools to help the portfolios from today forward.
Please feel free to give us a call if you would like to discuss this or anything else further.
The Meritage Investment Team