As the summer heat settles in, I am reminded of taking my daughters to swim classes. The ability to swim, and be comfortable around water, is something parents often wish to instill. I also remember the first time I saw them jump into the deep end of the pool. I had every confidence they could swim, but there was that brief moment, while they were under water, that I wanted for their safety. Much like the concern for my children years ago, for brief moments we collectively worry about the economy as it dives into the deep end, but know that it too will eventually pop back up. Green shoots of growth in Leading Economic Indicators can be found if one looks, and while we need a few more months of data to confirm, it is not as dire as the media portrays. While it may be difficult, we should trust the economy will once again return to normal or, as may be the case, resurface.
As I wrote in the weekly email, inflation remains the number one problem. There are two basic ways to address this issue. The first is by increasing supply, and the second is by decreasing demand. Given supply chain constraints, the Federal Reserve is left with the task of tackling inflation by trying to weaken demand. To do this it is raising short-term interest rates, and unwinding its $9 trillion balance sheet.
In the past, the Fed has been very cautious not to upset the stock market. However, with inflation at current levels, it doesn’t have that luxury. The equity markets are rightfully nervous that the Fed will overuse its strategies and create a worse-than-expected economic slowdown. This is one of the main reasons for the equity market sell-off. Add to this that we are experiencing the worst bond market in 40 years, and you get a short-term recipe for uncertainty and volatility.
The market often reacts in advance of economic data. It will decline ahead of a recession, and often recover before the recession has even been called. However, while we’ve become accustomed to quick “V-shaped” market recoveries over the past several years, that is not always the case. It is more typical that we experience a “U-shaped” market recovery which happens when the market bounces along the bottom for a few quarters.
With all of this as a backdrop, there are positive signs. First, the macroeconomy, while slowing, is still doing well, and if we have a recession, we do not expect it to be deep, or long-lived. Second, we believe we are experiencing peak inflation now, and expect it to decline through the second half of the year. This will be a welcome sign to the equity and bond markets. Third, the labor markets are very strong. Fourth, retail sales, while slowing slightly, have been resilient.
Ultimately, the markets are waiting for news of lower inflation which may take another two to four months. This means that heightened volatility will remain a bit longer, and we may retest the previous bottom. This retesting could be of the low we had a few weeks ago, or it could be of a lower low from a previous period. Historically, the market will retest a bottom multiple times before making a sustained turn higher. Rest assured, this retesting is a positive sign.
I understand this part of the economic cycle is worrisome for some, and want you to know we will walk through this together. Our door is always open if you want to meet and we’re only a phone call away if you need to talk. I have every confidence that this market and economy will recover. As always, we thank you for the trust you place in us.
Marc Henn, CFP®