Who is on first, what is on second, I don’t know is on third. Some of you remember this phrase as a setup for Abbott and Costello’s baseball comedy routine. Others have no idea what I am talking about. (If you count yourself in the latter category, do yourself a big favor and look it up on YouTube – it’s funny!)
That old Abbott and Costello skit is a conversation between a baseball team manager and a fan. From the point of view of the team manager, the conversation makes perfect sense. From the perspective of the baseball fan, it’s all complete nonsense. Today, this seems to be the situation between the Federal Reserve (the team manager) and the market (the fan). The Fed communicates that inflation is temporary – but the market sees it as quite persistent. The Fed says the economy will keep growing, because households are in a great position to spend – but the market sees data showing that 40% of consumers have less than $1,000 in savings, and the savings rate as a whole has dropped from 12.6% in 2021 to 4.4% as of data from April.
The Fed is looking to engineer a “soft landing,” in which the economy slows down but does not go into a recession. The market is not nearly as confident about that, either. Add in the prospect of earnings pressure, rising interest rates and further disruptions in global sourcing (with war, virus lockdowns in China, sanctions and more), and the picture becomes still more disquieting. What makes it even more difficult is that investors still see a wide range of potential economic results on the horizon – and their lack of consensus continues to manifest itself in the form of volatility.
Market activity in June provides a good example of why investment timing is so difficult. The S&P 500 declined 11% between June 8 and June 16, followed by a rise of 6.7% from June 17 to June 24 (the most recent date available as of this writing).
Bonds also exhibited a wide range of volatility, with the 10-year Treasury starting the month at a 2.90% yield, going up to 3.47% as of June 14. (Note that rising rates erode the market value of bonds.) Yields dropped to 3.09% by June 23 and are currently pushing higher again. Traditional portfolio allocations among asset classes such as bonds, stocks and real estate have not provided the customary insulation against market risk as they have done in the past.
What now? We expect inflation to remain elevated for the remainder of the year. We anticipate economic growth slowing. (The Atlanta Fed’s current gross domestic product indicator shows an expectation for zero economic growth as soon as the second quarter of this year.) We feel the equity market has done a good job pricing in anticipated interest rate moves, but has yet to comprehend the prospect of slowing corporate-earnings growth.
We see tighter credit conditions continuing to put pressure on valuations of companies that don’t generate profits in the small to mid-cap growth sector. We expect the best performing areas of the equity market to be legacy companies with profits and solid balance sheets. These also tend to be the companies most likely to pay dividends, which we see as a benefit in the environment moving forward.
It is an understatement to say the bonds have struggled in the first half of this year. We expect the worst is behind us in the investment-grade bond market as investors look to this allocation as economic growth concerns crystallize. High-yield junk bonds could come under more pressure in tighter credit markets and slowing economic growth. We continue to favor U.S. allocations over developed foreign allocations in both bonds and stocks.
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