We have relayed this message in the past: Wall Street hates uncertainty, and, right now, we seem to have an unlimited supply of it – uncertainty regarding inflation, uncertainty regarding Fed policy and interest rates, uncertainty surrounding when the supply chain will remedy itself, uncertainty regarding whether the Federal Reserve can engineer a soft landing for the economy, and uncertainty regarding China’s ability to control the virus and keep its economy running, which continues to compound the world’s supply chain issues. All of these uncertainties are on top of the unknowns surrounding Russia and the war in Ukraine.
Through Wednesday’s close, the tech-heavy Nasdaq Composite and the Russell 2000 Index (small caps) have endured the most damage, down 29.9% and 30.1%, respectively, from their highs. The S&P 500 Index and the Dow Jones Industrial Average (DJIA) are down 18.3% and 13.8% from their respective highs. In addition to the equity market losses, the AGG, the U.S. Aggregate Bond, is down 12% from its high.
A change we have noticed is the “buy-the-dip” mentality is taking a sabbatical. For the past five years, buyers have stepped in quickly during corrections, resulting in fast recoveries spoiling investors; yet, this time around, investors are not buying the dip. Why the change? Previously, we were generally dealing with one uncertainty at a time, while this period is marked with a perfect storm of multiple uncertainties, and, as a result, investors are being more cautious before adding fresh capital to the markets. Furthermore, this downturn differs from a more stereotypical bear market in that this time, bonds have not offset a portion of the losses in equities because of the rising rate environment. Consequently, conservative portfolios have lost money in both bonds and equities in 2022, which is a rare occurrence when there is not a credit default risk like we had in the Financial Crisis of 2007-2009.
So, what turns this around? One by one, we need the uncertainties listed above to dissipate. The big bogey is controlling and then hopefully reversing our current inflationary environment. The Federal Reserve is in the early stages of increasing the Fed Funds Rate with the expectation that higher borrowing costs will reduce demand for housing, goods, and services, thus reducing the current supply chain imbalance. Many are complaining that Jay Powell and the Federal Reserve need to move faster on the rate hikes in order to control inflation. The Federal Reserve is trying to engineer a soft landing by slowing the economy without driving the economy into a recession. I believe the Fed is moving at the appropriate pace and the bigger, more stubborn issue is the time it is taking to repair the global supply chain. China’s “zero-COVID” policy is unsustainable – as the World Health Organization (WHO) has stated – and continues to wreak havoc with the global supply chain.
On the bad news/good news front, the (hopefully temporary) wealth destruction we are experiencing in the global markets will reduce demand for goods and services faster than the Fed’s rate hikes will reduce demand. The rise in mortgage rates should put a lid on housing prices, and goods and services inflation combined with the spike in energy prices is stretching the budgets of all low- to middle-income households. Add in that the stimulus programs have ended, and that should result in a substantial decrease in demand for many American families, which will reduce overall demand for housing, goods, and services. Inflationary pressures and the end of the stimulus programs will likely result in workers returning to the labor force and an ease in wage inflation.
Also on the bad news/good news front, investor sentiment is near historic lows, which is often a great contra indicator. Put simply, when investors want to throw in the towel, that usually means we are starting the bottoming process. Berkshire Hathaway (Warren Buffett’s conglomerate) seems to agree, as it recently disclosed it invested more than $51 billion of its cash in the first quarter. For context, Berkshire had been accumulating cash for the prior two years, waiting for a better buying opportunity.
Overall, we believe we are entering the capitulation phase of the sell-off, but we remain cautious and would like to see signs that inflation is slowing before making any significant moves with new capital. Investors typically look ahead six to 12 months when evaluating the economy, but, right now, the focus is on the moment due to the breadth and depth of the current laundry list of uncertainties. That being said, the opportunities are becoming more noticeable on a daily basis.
We will keep you posted.