What was already one of the worst starts to a year for stock and bond markets has gotten worse. Inflation continues to be more persistent and stickier than the market originally expected. In turn, the Fed has adopted a much more aggressive policy response than they were forecasting in the first quarter, let alone last year. The market is not just adjusting to changing Fed policy, it’s adjusting to the rate of that change. The Fed has shifted their stance one too many times for the market’s liking, and the result now has turned into a bit of a “sell now, ask questions later” market environment.
The market is bracing for a recession
Our core belief this year has been that, outside of a recession, the market will bottom once bond yields top out. Because yields move inversely to price, that means bond prices need to bottom before stocks can bottom too. If you’re looking for an easy way to track the bond market, add the ticker AGG to your watchlist. This is an aggregate bond index ETF that tracks the “total US investment-grade bond market.” (You can loosely think of AGG as the S&P 500 for bonds in that it is a popular benchmark for bond investors).
The near-term concern we have is that the market is starting to believe we are in, or entering, a recession. We say this because market declines are generally capped at 20% outside of recessions, but the current drop has reached more than 23%. In addition, we saw two different reactions from AGG immediately following the last two Fed rate increases.
Following the Wednesday, May 4th interest rate hike of 0.50%, AGG fell 1.40% on Thursday and Friday (the S&P 500 fell 4%). Following the Wednesday, June 15th interest rate hike of 0.75, AGG rose 0.20% on Thursday and Friday (the S&P 500 fell 3%). In contrast to the May hike, AGG’s stability following the June hike, accompanied with a further sell-off in stocks, could be a sign of a recession bid creeping into the bond market. Bonds often benefit from recessionary periods as investors seek safety in what is usually a deflationary economic contraction. Since 1980, AGG posted positive returns during each of the following recession years: 2007-2009, 2001,1990-1991, and 1980-1982.
Does that mean it’s right?
So if the market is starting to price in a recession, does that mean one is a foregone conclusion? Further, how much more would stocks have to fall before one is fully priced in? On the first point, we don’t believe in fighting with the market. We can only listen to what it is trying to tell us and use that information to try and make informed decisions. But like a toddler, (trust me, I know), markets can change their mind quickly.
In effect, that’s what happened this month. The S&P 500 fell nearly 12% in the span of six days (from June 8-June 16). This swift fall was the market changing its mind to include “recession fears” in the forecast. Previously, we would argue, this decline had been much more about a repricing of risk due to higher bond yields. Bond yields were moving higher, so stocks were inherently worth less. Now, we have a repricing of risk plus recession fears.
However, those recession fears can abate as quickly as they showed up. In other words, as a recession becomes the market’s baseline expectation, avoiding one creates the potential for a major positive catalyst in the months ahead. What if we do have a recession? Since 1938, the S&P 500 has lost an average of 32% (median 27%) leading into and during recessions. Based on closing prices from June 17th, that would equate to a further drop in the S&P 500 of 11% (average) or 4.40% (median).
Avoiding the 30% threshold
From a historical perspective, there is good reason to be rooting for the market to bottom between this -20% and -30% range (aside from just losing less money). 1, 3, and 5 year forward returns are much stronger when the market can bottom before reaching a 30% decline:
The 30% decline threshold in the S&P 500 is around 3,360 (~8% lower from current prices). One of the main things to watch for in the market is further stability in the bond market that does not lead to a bounce for stocks. This would be a strong signal that the market is continuing to brace for a recession. Should bonds and stocks start to bounce back together this would be an excellent sign that the market views inflation as having peaked, and the economy avoiding a recession.
Unlikely, but very interesting, would be if bonds kept falling but stocks starting going back up. That could signal that the market is adopting a permanently higher view of inflation while starting to bet that stocks, from these valuations, will be an adequate hedge against that inflation.
The worst-case scenario would be if bonds and stocks continue to fall together, like they have for much of this year. That scenario can be explained this year thus far because of how rampant and persistent inflation turned out to be relative to where bond yields entered the year (near historic lows). But now, with bond yields at their highest levels in 11 years, it would signal something less clear if bonds and stocks continued to fall together from here.
Bonds should trade better from here
The bottom line is that the pain is real right now and it could get a little worse before it gets better. Whatever confidence the market had in the economy to avoid a recession has diminished greatly since June 8th, when stocks fell nearly 12% in just six days. While even diversified portfolios have been hit hard this year, they are still holding up better than concentrated ones.
A diversified index has fallen 19% year-to-date, compared to 22.40% for the S&P 500. We expect bonds to trade better from here, which should aid diversified portfolios even more. And if the economy can stay steady, there is a recipe for a solid bounce in stocks in the second half of the year as recession fears ease.
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