Since we last reported to you, the financial markets have continued their volatility as rising interest rates weigh on stock valuations and slow the economy. While this pullback has caused angst, it has also created opportunities for long-term investors and sown the seeds for more favorable returns going forward. We offer the following thoughts as we move into the final quarter of the year.
- First, while nearly impossible to predict the direction and magnitude of interest rates, the financial markets are starting to suggest that the worst of rising rates may be over, as evidenced by the long end of the yield curve. This could, in turn, help the stock market stabilize. While the Fed will continue hiking the short-term rate until inflation slows, several indicators showing a slowing economy are already helping to bring longer-term yields down from their recent highs.
- While the headline consumer price index (the Fed’s preferred inflation measure) remains elevated, other indicators such as commodity prices, breakeven inflation rates, consumer surveys, and producer inflation have recently moved lower, suggesting that CPI could soon follow suit. The “base effect”, which is the impact of older data falling out of the calculation, is likely to help as well. Said differently, headline inflation is of concern, but the nuanced data paints a slightly different picture.
- If this plays out as the market is anticipating, concerns might arise that the Fed may move from “not doing enough” to “doing too much.” This could increase the potential for a policy pivot which would help take some pressure off the market.
- We do believe the risk of a recession remains elevated. That said, the underlying data suggests that a recession could be a more “garden variety” version versus the one we experienced in the great financial crisis of 2008-2009. For example, the labor market, with more job openings than unemployed people, remains very strong. Additionally, the fact that the economy hasn’t slowed fast enough is part of the reason the Fed has continued to raise interest rates. Finally, the balance sheets of global banks are much stronger than in prior recessions.
- Markets typically bottom before the economic data does, as they are considered the ultimate “forward-looking indicator”. The point of maximum pessimism is typically the time where you see the best forward-returns in investments. While we aren’t calling a bottom, pessimism (as evidenced by various sentiment surveys) is at the lowest point since March of 2009, the doldrums of the last recession.
While this uncertain backdrop remains challenging, clients of Greenwood Gearhart can take comfort in the high-quality skew of our portfolio companies: strong balance sheets, cash generative, high market share, competitive advantages, and low leverage. These companies are leaders in their sectors and among the best run companies in world. As a result, your portfolio is well equipped to not only weather the current storm but participate strongly in the recovery as the economy normalizes. The recent volatility has also provided us opportunities to “upgrade” the portfolio, by acquiring high-quality companies which were previously out of our reach. As a result, we believe we are sowing the seeds for future performance.
Lastly, for those of you who own fixed income in your portfolio, we wanted to briefly discuss the bond market, which has been under pressure due to surging yields. Greenwood Gearhart has maintained a core view for some time that long-term bonds have more risk than meets the eye, and as a result has skewed heavily towards short duration bonds with less interest rate risk. This has added significant value versus the broader bond market this year in our portfolios and helped buffer against equity returns. With yields now more attractive, we are starting to find better opportunities in slightly longer duration bonds and have moved slightly further out on the yield curve in recent weeks. While we usually write about the stock market, know too that we are also closely monitoring fixed income markets amid this volatility.
We remain available at any time to review your investments and discuss your portfolio in-depth, either in-person or virtually - please don’t hesitate to reach out and set an appointment. Thank you for your continued trust and confidence in our firm.