As we near the start of the fourth quarter, the million-dollar question still left unanswered is this: Can the Fed successfully bring down inflation without forcing the U.S. economy into recession? The probability that they can has decreased significantly over the past few months—and what not long ago appeared to be an achievable outcome, looks nearly impossible. In fact, some may argue that our two consecutive quarters of negative gross domestic product indicates that we are, in fact, already in a recession. However, other economic data still suggests otherwise, and until the National Bureau of Economic Research indicates such, we are not. Historically, not all consecutive quarters of negative GDP have resulted in a recession, nor have all recessions had consecutive quarters of negative GDP. Regardless, managing inflation down from 40-year highs (9.1% in June) to the Fed’s target of 2% will not be done without some amount of pain. The likely outcome is that the Fed is not able to navigate a soft landing, economic growth will continue to slow into 2023, inflation will remain persistent well into 2023 (maybe even 2024), the unemployment rate will increase, and the housing market will continue to see contraction.
What does all this mean for the fixed income and equity markets?
In its quest to combat inflation, the Fed recently raised its federal funds rate to its highest level since 2008. Five rate increases this year and three consecutive hikes of 0.75%, mark the most aggressive Fed tightening in over 30 years. It is expected that the Fed will raise rates at each of its two remaining meetings this year and likely again to start 2023. Currently the U.S. 2 Year Treasury is yielding 4.1%, with the U.S. 10 Year Treasury at 3.7%. Last year at this same time, yields were 0.22% and 1.3%, respectively. The average 30-year fixed mortgage rate is 6.55%, having topped 6% in early September, a first since 2008. This compares to an average rate of 2.65% during 2021.
Increased fear that the aggressive Fed tightening will result in a hard landing or recession has the major equity markets heading toward their fifth decline in the past six weeks and nearing their 2022 closing lows set in June. The S&P 500 index is down 21% so far in 2022. The near-term outlook on inflation, economic growth, interest rates, corporate earnings, and valuations are cloudier than we have seen in some time. This will likely continue to weigh on stocks through the remainder of the year and into next.
On the bright side, corporate earnings have proved resilient, with second-quarter results being much better than expected. More than 70% of companies beat their earnings forecast, and overall earnings growth has been 3–4%. This is slower than the past few years but is positive, nonetheless. While the road ahead will be more challenging, as a whole, U.S. companies were on sound financial footing heading into 2022, and that should serve them well as they navigate the increasingly challenging environment that lies ahead.
While foolish to forecast the near-term direction of the stock market, we do know that markets typically top out before the start of a recession and bottom out in advance of the conclusion. Since 1975, the average return for U.S. stocks in the year following a recession has been 16.3%. The U.S. stock market has routinely recovered from crisis events and recessions to move higher over longer time periods. Staying invested so you do not miss the market’s best days has always proven a better strategy than locking in losses and risking the opportunity to participate in the recovery.
As always, your relationship team is here to meet with you in whichever way is most comfortable for you. We value your relationship and the confidence you have placed in Adirondack Wealth Management by choosing us as your financial partner.
Senior Vice President
Wealth Management Director