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Inverted Expectations

Doug Johnson CFA, Senior Investment Strategist

After an extremely rocky start to the year, the last few weeks have provided some respite for equity markets. A strong rally that began the day the Fed raised rates for the first time since 2018 has continued through to the quarter’s end as investors continue to digest projections for earnings, economic growth, inflation, and the path of expected rate hikes. The conflict in Ukraine is ongoing, along with supply issues for the various commodities that are produced and exported from the region. China is reporting a significant uptick in COVID cases and has moved to lock down a number of cities to stem the outbreak.  This has led to renewed fears of supply chain disruptions.   

Q1 was certainly a challenging environment for investors, as returns for both stocks and bonds ended the quarter in negative territory. In addition, we have seen yield curve inversions across various time frames, some of which haven’t appeared since 2007. Most notable and arguably most important, the 2 year/10 year spread inverted last week for the first time since 2019. 

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As a quick reminder, the yield curve denotes differences in various interest rate levels along the entire spectrum of maturities for US Treasury bonds. The chart above illustrates the curve at various times over the last year.  An inversion takes place when a shorter maturity yields more than a longer maturity. We highlight the 2 year/10 year inversion above as you can clearly see the line in red having a dramatically different shape than the lower lines.

Why Should We Care About the Shape of the Treasury Yield Curve?

The 2 year/10 year yield curve inverting has historically been a reliable predictor of recession. There is some lag time between when the inversion happens and when the actual recession begins, but the more important takeaway is that the bond market is seeing economic growth slowing. Looking at the global landscape, it is easy to see why bonds may be pricing in a slowdown. Inflation remains high, which at some point will lower demand as consumers change their spending habits to avoid higher prices on goods that may not be “necessities.” In addition, corporations will see their profit margins shrink as higher input costs will either need to be passed on to the end user or absorbed. 

Despite the warnings from the bond market, equity markets seem to be taking this all in stride, almost oblivious to the headwinds that, for now, don’t seem to be abating. The rally off the first quarter lows has been impressive, reminiscent of the March 2020 recovery where the bear market caused by the onset of COVID was erased in the blink of an eye. Could it be possible to see a repeat of that rally? 

It’s not impossible, but it isn’t very likely, either. Why is that? The COVID recovery, along with most major market recoveries since 2009, have been accompanied by some type of accommodative Fed action (rates cuts, QE, etc.). And almost every single time the Fed had room to act because they were not restricted in any way by inflationary pressures. Today, inflation is running at its highest level since 1981, along with additional supply issues that don’t seem to be getting better any time soon. With an explicit mandate to “fight inflation,” the Fed now has very little room to ease policy. 

The market still seems to think the Fed isn’t serious about inflation. Powell and company continue to talk about being tough on inflation, but only raising rates 0.25% when inflation is running at 7.5% doesn’t seem very tough. In fact, many believe the Fed is so behind the fight that rate markets are now pricing in two 0.50% hikes in May and June. The Fed hasn’t raised rates .50% in a single meeting since May 2000!! 

The biggest risk we see now is that the market still underappreciates the Fed’s resolve to squash inflation and/or the Fed’s reluctancy to favor stable market conditions over lower inflation. To be fair, investors have been conditioned to expect a “rescue” of some sort when things get too volatile. They have also been conditioned to expect quick resolution. The 2000 and 2008 bear markets were the last two sustained periods of decreasing market prices, both accompanied by recession. Those drawdowns lasted 18 months on average. Since 2009 and the introduction of Quantitative Easing, the average drawdown has only lasted about 4 months.  

Maybe the Fed has changed the pysche of the market enough to where market cycles have become much shorter and investor expectations for quick turnarounds are justified, despite whatever headwinds exist on the macro landscape. Our view remains that the Fed’s ability to provide a safety net has been diminished, and we’re not sure the market fully appreciates that. However, if the Fed pivots and accepts higher inflation in exchange for continued policy accommodation, the market will have won this game of chicken and very well could continue to new highs.   

Weekly Focus – Think About It

“A creative man is motivated by the desire to achieve, not by the desire to beat others.” 

  • Ayn Rand 

Market Activity

Performance last week for the four major asset classes were:

  • U.S. Stocks – Russell 3000 (IWV) – Gain of 0.19%
  • Developed Foreign Markets (EFA) – Gain of 0.72% 
  • Emerging Markets (EEM) – Gain of 1.89%
  • Fixed Income (AGG) – Gain of 0.76%  

(Note: performance is based on the change in price plus dividends)

Last Week’s Headlines

  • Most major equity markets end the first quarter of 2022 lower, with the S&P 500 down around -5%.
  • Core PCE inflation, the Fed’s preferred inflation gauge, continued to reflect historically high inflation, coming in at 5.4% for February.
  • The 2 year/10 year US Treasury Yield curve inverted for the first time since 2019, signaling concerns about economic slowdown and possible recession over the next 12-16 months.

Eye on the Week Ahead

  • Core CPI and PPI will be closely watched for the most recent reading of inflationary pressures and how that may affect the Fed’s decision to increase rates at the May meeting.
  • Retail sales will provide clues on whether or not inflation has affected the consumer’s willingness to spend.

If you have questions about the recent market conditions, please contact a member of HCM’s Wealth Advisory Team:

  • Mike Hengehold
  • Casey Boland  
  • Jake Butcher 
  • Jim Eutsler   
  • Greg Middendorf
  • Steve Hengehold 
  • Doug Johnson 
  • Matt Calme
  • Disclaimer:

     Any tax or other advice contained in this document, including any attachments, is not intended and cannot be used for the purpose of avoiding penalties under Internal Revenue Code. No action should be taken on any information contained in this message without first consulting with your tax/legal advisors regarding the tax/legal consequences for your particular circumstances.

     Additional Notes:

    • The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.
    • Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
    • Past performance does not guarantee future results.
    • You cannot invest directly in an index.
    • Consult your financial professional before making any investment decisions.

     • • •

    Doug Johnson CFA, Senior Investment Strategist  Doug Johnson CFA
    Doug is the Senior Investment Strategist in the Investment & Research Department.  He guides the Investment Committee in developing and implementing HCM’s investment strategies. Doug and his wife Cindy live in West Chester with their two sons. In his free time, Doug enjoys family time, golf, playing and watching hockey, and travel.
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