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Key Points for the Week

  • The S&P 500 officially entered a bear market by closing more than 20% below its all-time high.
  • The Federal Reserve raised interest rates 0.75% as the central bank plays catch up after leaving rates too low for too long.
  • U.S. retail sales slowed 0.3% last month in response to heightened inflation, while industrial production remained strong. Even with the decline, retail sales are up 8.1% from last year.

Be Aware of Identity Theft

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Economic Update

Last week, the Federal Reserve (Fed) delivered a message that it is serious about fighting inflation. The Federal Open Market Committee (FOMC) lifted the federal funds target rate by 0.75 percentage points. The fed funds rate is now 1.50 percent to 1.75 percent.

The Fed also has begun to shrink its $9 trillion balance sheet by selling Treasury securities and agency mortgage-backed securities, a process known as quantitative tightening (QT), reported Kate Duguid, Colby Smith, and Tommy Stubbington of Financial Times (FT). The Fed’s balance sheet expanded greatly during the past few years as it engaged in quantitative easing (QE). QE entailed buying Treasury and agency securities to ease financial conditions, strengthen the economy, and support markets during the pandemic.

If QT was a rate hike, it would be “roughly equivalent to raising the policy rate a little more than 50 basis points on a sustained basis,” according to a paper published by the Fed in June. Although, the authors stated there was considerable uncertainty associated with the estimate. It is hard to be certain about what will happen when the Fed has only attempted QT once before.

Global markets weren’t enthusiastic about the fact that the Fed and other central banks are tightening monetary policy. Harriet Clarfelt and colleagues at FT reported, “US stocks have suffered their heaviest weekly fall since the outbreak of the coronavirus pandemic, after investors were spooked by a series of interest rate increases by big central banks and the threat of an ensuing economic slowdown.”

It’s likely that markets will continue to be volatile, according to the CBOE Volatility (VIX) Index®, which measures expectations for volatility over the next 30 days. The VIX is known as Wall Street’s fear gauge. Last week, it rose to 31. That’s well above its long-term average of 20.

This Week in the Markets

The S&P 500 dropped last week and is now 22.3% off its peak. This decline pushed the index of large-cap U.S. stocks into a bear market, which is defined as a 20% or greater drop from its peak. Volatility remained elevated, and the S&P 500 has now moved by 1% or more 60 times this year.

Much of the decline can be traced to the Federal Reserve raising rates 0.75%, signaling the central bank views more rapid action as necessary to tamp down inflationary pressures. With the hike, the Fed’s benchmark fund rate has a range of 1.5%-1.75%. It was the first time since 1994 that the Fed has raised 0.75% in one meeting. The Fed also raised its expectations for interest rates in each of the next three years, suggesting additional rate hikes should be expected.

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Some economic data indicate the pressure on prices might be edging lower. Producer prices rose 0.8% last month but only 0.5% when food and energy is excluded. While up 10.7% in the last year, that is 0.9% lower than it was two months ago. Retail sales fell 0.3% last month. Consumers are pulling back from purchases in the face of higher prices.

Global stocks moved similarly to U.S. stocks last week. The MSCI ACWI also fell 5.7%. The Bloomberg U.S. Aggregate Bond Index shrank 0.9% as bond prices fell in response to the expectation of higher rates. A host of Purchasing Manager Index reports will be released this week and will help identify if economic activity remains strong.

Bear Market

We are back in a bear market. After a couple of close escapes, the S&P 500 broke through the down-20% threshold and entered a bear market early last week. Unlike the COVID bear market in early 2020, this decline has taken a while. The S&P 500 peaked on Jan. 3, 2022, and has slid 22.3%, including dividends, from that peak. The decline has accelerated in recent months with the S&P 500 falling 18.6% in the second quarter. Other sectors of the market, including the NASDAQ composite, are down more than 30% from their highs.

Why did the markets drop? Inflation and the Fed’s interest rate hikes were the primary causes. Markets moved into last week still trying to digest the larger-than-expected inflation report from the previous Friday. The news didn’t go down easy and expectations for a 0.75% rate hike started to increase. Those expectations were fulfilled on Wednesday, when the Fed raised rates 0.75% for the first time since 1994.

The Fed moved aggressively because it delayed tightening monetary conditions and is trying to catch up. In its official statement, the Fed recommitted itself to getting inflation back down to 2 percent. By increasing rates, the Fed will make borrowing more expensive, and less borrowing makes the economy expand more slowly, reducing demand and allowing prices to decline.

The Fed faces a difficult challenge because rapid interest rate hikes can harm key segments of the economy and markets don’t have time to adapt to changing expectations. Markets dropped last week partly due to concerns the Fed will keep raising rates rapidly and push the economy into recession sometime next year. Fears of a recession next quarter seem overblown given the continued strength in labor markets.

The Fed isn’t the only central bank battling rapidly rising prices. Inflation is a global phenomenon and many countries have been increasing rates. Last week Switzerland and England both raised rates. The 0.5% increase in Swiss rates was a surprise to many while the English raised rates by 0.25% for the fifth straight meeting. Previously, the European Central Bank announced it would raise rates at its July meeting.

Given all this information, what should investors expect from the market? In the short term, markets are expected to stay volatile. There have already been 60 moves of 1% this year and those are likely to continue given the uncertainty. Inflation data, such as the Personal Consumption Expenditures Pride Deflator (PCE) and the Consumer Price Index, will likely have outsized impact. We will be paying close attention to communication from Fed governors about the future direction of rates. We’ll also be watching energy prices closely. Producer and consumer prices were pushed higher because of energy prices, and we expect prices in other areas indirectly affected by higher energy costs to rise.

Markets often rally after entering bear markets because investors reach a point of high pessimism. During declines, it is easy to identify the challenges market face. The case for why things will improve is often more nuanced and less vivid. Yet, based on historical performance, the most realistic assumption is the market will recover eventually and patience is often the most important investor virtue. Anything you can do to stretch out your time horizon can help make investing less challenging and more rewarding. Please let us know if there is anything we can do to help you.

Is the Bond Market or Stock Market a Better Recession Indicator?

The stock market has been dropping, but that doesn’t necessarily mean a recession is ahead. The stock market isn’t very accurate when it comes to predicting recessions.

In 1966, following two decades of almost uninterrupted economic growth and stock market gains, a bear market arrived. Stock investors feared a recession might be ahead, and the S&P 500 Index dropped 24 percent over eight months before rebounding and moving higher.

Economist Paul Samuelson, the first person to win a Nobel prize in economics, quipped, “The stock market has predicted nine out of the last five recessions. A factcheck of Samuelson’s off-the-cuff remark in 2016 found that he was right. Bear markets in stocks lead to recessions about 53 percent of the time, reported Steven Liesman of CNBC.

In other words, the stock market has about the same predictive value for recessions as a coin toss. The Treasury bond market has a far better record.

In normal circumstances, yields on Treasuries rise as maturities get longer. So, a two-year Treasury bill will normally yield less than a 10-year Treasury note. On occasion, shorter-maturity Treasuries yield more than longer-maturity Treasuries. This is unusual because investors usually want to earn more when they lend money for a longer period of time. When two-year Treasuries yield more than 10-year Treasuries, we have an inverted yield curve. (The name, “yield curve,” describes how the data looks on a chart.)

An inverted yield curve is a more reliable indicator that a recession is ahead. Alexandra Skaggs of Barron’s explained, “In a recent study of yield curve inversions, BCA Research found that the gap between 2- and 10-year yields has inverted before seven of the past eight recessions...The gap between 3-month and 10-year yields has a better record, calling all 8 recessions without a false signal.”

At the end of last week, the yield curve was not inverted. Three-month and two-year Treasuries were yielding 1.63 percent and 3.17 percent, respectively. The 10-year Treasury was yielding 3.25 percent.

Did you Know? This Week in History

June 20, 1975: “Jaws” Released in Theaters

On June 20, 1975, Jaws, a film directed by Steven Spielberg that made countless viewers afraid to go into the water, opened in theaters. The plot that featured a great white shark terrorizing a New England resort town became an instant blockbuster and the highest-grossing film in movie history until it was bested by 1977’s Star Wars. Jaws was nominated for an Academy Award in the Best Picture category and took home three Oscars, for Best Film Editing, Best Original Score and Best Sound.

With a budget of $12 million, filming took place on Martha’s Vineyard, Massachusetts, but was plagued by delays and technical difficulties, including malfunctioning mechanical sharks. Jaws put now-famed director Steven Spielberg on the Hollywood map. Following the success of Jaws, Spielberg went on to become one of the most influential, iconic directors in the film world.

Weekly Focus

My interest is in the future because I am going to spend the rest of my life there.

Charles Kettering, Engineer

The optimist proclaims that we live in the best of all possible worlds, and the pessimist fears this is true.

James Branch Cabell, Author