Market Navigator – September 2022 edition

Monthly letter

We are landing, soft-ish or not. That was the take home message from Federal Reserve (Fed) Chair Powell’s Jackson Hole speech in mid-August that led to a 1,000-point decline in the Dow Jones Industrial Average and subsequent market selling. And, while a soft economic landing (avoiding recession) is still the goal, the Fed is prepared to do whatever it takes to bring down enemy number one, inflation. This is the case even if that means keeping interest rates at an elevated level for longer, which causes short-term economic pain in the form of a hard economic landing (recession). Indeed, historically, once inflation is above 5%, it has generally taken a recession to bring it back down.

Powell’s speech reinforced a key factor that had led us to be more cautious headed into the meeting. The market went from pricing in a recession, down almost 24% at the June low, to fully embracing a soft landing and a Fed pivot on the subsequent 17% rebound. This left little room for error in a time of unusually wide outcomes. And markets subsequently gave back roughly half of the prior gains in the back half of the month. This setback coincided with a sharp rebound in interest rates.

The scar tissue left behind at the Fed due to the inflation challenges of the past year should not be understated. That is, even when the Fed eventually does pivot, the amount of stimulus and duration of support will likely be somewhat restrained relative to the post-global financial crisis era.

Recall, despite all the money printing of the prior decade and concerns that it would drive up prices, inflation never materialized. Now, however, inflation has reared its ugly head. Missing the opportunity to deal with it in its early stages will likely haunt the Fed for years to come.

If we are right about this shift in psyche, this will likely lead to more volatility in the business and market cycles as the Fed is no longer on perpetual call. Thus, a more tactical investment approach will likely be warranted.

Our core view is we expect the markets to remain in choppy waters and still advocate for a more defensive and up-in-quality portfolio positioning. However, markets do not typically move in a straight line. On a short-term basis, several indicators suggest the selling is getting overdone. Of course, oversold markets can get more oversold. Still, after advocating for trimming equities on strength, we would be less apt to do so now – at least over the short term.

Even while it has its own challenges, given its status as the big blue-chip country, we maintain our long-standing U.S. equity bias relative to international markets. Our preferred areas within the U.S. include defensive segments—such as dividend stocks, consumer staples, utilities, and health care— which are less reliant on the strength of the economy. We maintain our long-standing positive stance on the energy sector even though there are risks to the sector given the global economic slowdown. That is partially offset by low supply levels and geopolitical concerns.  

Similarly, we remain focused on higher quality fixed income, such as government bonds, where yields are productive again, and have a less favorable view on lower quality bonds, such as high yield, given the risks to economic growth.