Year-End Market Outlook: The Big Question (Part 2)
These hikes to the interest rate are largely cited as the catalyst for the strong sell-off across most investable assets in 2022. This violent Fed rate hiking regime has seen rates rise both higher and faster than in any other hiking cycle in the same 40-year period.
If aggressive Fed action is truly to blame for this year’s sharp asset sell-offs, we need to map the potential Fed funds path going forward. We believe that path will largely be predicated on the following:
- WHETHER inflationary pressures continue to rise higher than expected.
- IF there is an economic recession, what is the magnitude? (A severe recession has the potential to be inherently deflationary and prompt fast Fed rate cuts.)
- WHETHER economic activity and inflationary pressures normalize over time as a result of current Fed activity (amongst other factors).
The economists at Goldman Sachs, a CWM trusted investment partner, estimate that in a worst-case scenario, the Fed could increase interest rates to as much as 6% by late 2025. This is illustrated in the next chart (see the red line) and while unlikely, has the potential to be detrimental for investors. Under this rate hike scenario, an economic recession (especially a severe one) would likely be a negative for more aggressive investment types like stocks. As a counterpoint, Goldman Sach’s baseline expected prediction is that the Fed Funds rate will climb to 4.4% by year end and to 4.6% in 2023, with a decline to 3.3% by 2025 (depicted by the dark blue line below). Any of the non-redline scenarios shown would arguably be beneficial for bond investors, as they represent a higher probability of a near-term peak in Fed rate hike activity. Lower rates would arguably be good for all investable assets. However, that may not be the case for stocks if rates were falling in response to significant economic weakness (like a recession) that is typically not a good timeframe for corporate earnings and related market valuations.
For plan participants practicing risk management in the more conservative portfolio types, those portfolio exposures remains highly defensive in bonds and bond-like instruments. While these “defensive” positions have not worked as well in the 2022 scenario as in previous sharp market sell-offs, they have still provided superior outcomes when compared to the 2022 performance of the major U.S. indices (ex. S&P 500, NASDAQ, or Dow Jones Industrial Average (DJIA)), which have seen losses from ~21% to ~32% since the start of the year through September 30th.1 Preservation of capital is important, and the CWM team expects typically defensive asset types to perform more in line with historical trends now that markets are beyond the initial early year shock of sharply higher inflation and related rate hike activity.
To provide further comfort and evidence for maintaining these positions, all investors should keep in mind that in any four-year period going back to 1926, bonds as a category on a total return basis, including dividend income, have never been negative (see chart below). This period includes inflationary environments, deflationary environments, stagflationary, rate hiking, and rate cutting environments. Perhaps the current scenario continues to be an anomaly and breaks this mold, but the evidence seems clear that maintaining investment discipline will provide a high probability for future positive portfolio outcomes. Ideally, portfolio risk can be successfully managed as the overall stock market works its way to the ultimate bear market low, from where the best future investment opportunities have historically existed. By maintaining as much investment capital as possible, and keeping some opportunity on the table, CWM is working to position client portfolios to take advantage of buy-low opportunities when they arise.
For CWM Risk-Adjusted Models: The CWM team believes that maintaining defensive positioning while awaiting a potentially more favorable risk-taking investment environment is still the most prudent course for the time being. Future allocation changes will be made as relevant datapoints change.
CWM Accumulator Models: The CWM team believes there is a high potential for continued market volatility and perhaps even further sharp market valuation drops in the near-term (0 – 2 years). A significant benefit of choosing a more passive investment style is the longer-term focus (5+ years) of the strategy and the ability to ignore day-to-day news, so long as discipline is maintained.
Part of having investment discipline is the responsibility of investors, who should, assuming they are able, continue to make portfolio contributions in line with their financial plans. New contributions are particularly important in scary market environments, where often the best future return (buy low) opportunities exist. Investors should always carefully consider which style will best fit their own needs, goals, and personal risk tolerance.
If you are interested in a deeper dive into the current market data, have questions, or would like to schedule an appointment with a CWM advisor please contact us or call the office at (425) 778-6160.
1Index performance data provided by Koyfin and is inclusive of income (total return). The date range of the performance shown is 12/31/2021 to 9/30/2022.
*The market indexes discussed are unmanaged and generally considered representative of their respective markets. Individuals cannot directly invest in unmanaged indexes. Past performance does not guarantee future results. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. No investment strategy can guarantee profit or protect against loss.
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