The stock market is a fickle barometer of the economy, for sure, swinging wildly in the short term as it grapples with the latest information. This process can be thought of as a mechanism looking to find equilibrium; moving around a great deal when uncertainty is high. This fittingly describes current market conditions.
As we wrote in our note one week ago, we are not surprised to see this market relief rally in the week just past. The market posted a strong rally in response to a relatively dovish Fed statement on Wednesday from a technically oversold position. Fundamentally, what did we learn in the week? Not much, really.
Here’s what we know:
- Valuations are still high
- Money supply is still high
- Inflation is still high
- Fed Policy is changing and has just begun
- The Russian war on Ukraine continues
Here’s what’s uncertain:
- How persistent the inflationary impulse will prove to be
- How aggressive the Fed response will be
- Whether the Fed tightening will lead to a recession
- How much economic dislocation the Russian war will cause
- Whether Russia’s war on Ukraine will broaden
Here’s what we think:
We think the Fed is behind the curve on inflation. With the Fed balance sheet still growing (adding liquidity to the economy when inflation is already setting forty-year highs) seems a bit reckless. Moreover, raising rates only 25 basis points is tepid and largely ineffectual given current economic conditions. Maybe market weakness prior to this meeting combined with the Russian war on Ukraine was enough to cause the Fed to forgo a more hawkish stance this time. But we forecast they will find themselves playing catch up soon. As they do, we will enter an environment to which not too many investors are used: a market without the implied backstop of the Fed put.
A best case as the Fed continues raising rates and lowering balance sheet assets would be a sideways market as earnings growth brings down stock market valuation multiples. This may happen. But we expect conditions will be a little rougher than this. A lot of uncertainty prevails. Along with this uncertainty we expect more volatility and unsettling headlines. This will eventually pass but we are expecting it to take quarters–not months.
Within investment portfolios, we continue to emphasize high quality stocks with strong dividend growth prospects. Additionally, we continue to find interesting investment strategies that fare well in higher volatility conditions and protect some against downside shocks. Speak to your advisor if you have specific concerns about your personal risk tolerance as these uncertain times continue. AS we said last week, these events are part of investing. In the long-term, things tend to work out OK.
Erik Ogard, CIO