Although the recent volatility can be unnerving, it’s important to remember that it is impossible to accurately predict changes in the economy and how they might affect markets.
September turned out to be a tough month for markets after performance started to look a little brighter late this summer. Earlier in the year, the key worry for markets was that the Federal Reserve was not acting fast enough to tighten monetary policy and that rising inflation was the predominant risk. Now, markets have reacted to growing concerns that the Fed and other central banks are tightening relatively severely, which could lead to a sharp decline in global economic growth.
What has led to the higher volatility after a brief summer rally?
Since mid-August, the U.S. stock market is down around 15%, and high-quality fixed income is in the –4% to –8% range depending on the fund or index. It’s likely that the weaker market performance reflects heightened expectations that the Fed, in its efforts to reduce inflationary risks, will continue to tighten monetary policy even if the economy starts slowing. How can we see this?
The first thing to observe is that real rates of interest — you can think of this as the amount of interest markets are paying relative to what inflation is expected to be — are now meaningfully positive and have increased significantly over the course of this quarter. Second, inflation expectations — meaning what the fixed income market expects inflation to be in the future — have declined significantly. Both these facts indicate that the fixed income markets believe the Fed is prioritizing inflation reduction. However, the risk that inflation stays higher for longer has not gone away; instead, the risk of a “hard landing” – or sharp economic slowdown – has become more pressing.
How are the major asset classes performing to date this year?
- Stocks: Most equity asset classes are down 20% or more year to date with even U.S. small-cap value stocks now down more than 10%. Further, quarter-to-date returns are now negative for all equity asset classes, which previously had been positive for some.
- Fixed income: Returns for all asset classes are negative quarter to date and are generally at their lowest points this year. Short- to intermediate-term, high-quality fixed income funds are now in the –7% to –14% return range year to date. Yields are generally up around 3%, which is an enormously large move in interest rates.
- Alternatives: This is one area of good performance. Most alternative asset classes are positive on a year-to-date basis, and the AQR Style Premia Alternative Fund is up around 18% year to date.
What’s the outlook for the rest of the year?
Given how sharply yields have risen this year — combined with the massive spike in energy prices, in Europe in particular — we should all expect increasingly gloomy economic data and predictions that it will continue to worsen from major news outlets. It is important to keep in mind that market performance is a leading indicator: you can expect economic data to worsen when global stock markets are down 20% or more (especially for many growth-oriented asset classes).
What are the upsides for investors in this environment?
Although the recent volatility can be unnerving, remember that no one can precisely predict changes in the economy and, more specifically, how they might affect markets. Here are some points investors can keep in mind in the meantime:
- Higher yields on fixed income are good news for long-term investors in short- to intermediate-term, high-quality fixed income. If you plan to hold fixed income investments for the long term, it’s beneficial to be investing when yields are higher versus lower, even though there is short-term pain on the way to higher yields. Owning short- to intermediate-term bonds mitigates this risk while still capturing the returns that higher yields may provide.
- Diversification has generally helped. Investors with allocations to value stocks, relatively short-term fixed income and alternatives have weathered the year far better than the broad market. We continue to expect that the most effective way to manage investment risk is sticking with a broadly diversified portfolio strategy rather than making substantial changes to portfolio allocations.
- Reacting after markets have fallen rarely works, and markets tend to lead economic data. With what we know today, expected returns are now higher in both stock and bond markets than they were at the start of the year. Although nothing is guaranteed, both stock and bond markets tend to do relatively well after periods of negative returns.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information is based on third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. U.S. Market above is measured by Vanguard Total Stock Market Index Fund (VTSMX), High Quality Fixed Income is measured by DFA Diversified Fixed Income (DFXIX), DFA Inflation-Protected Securities (DIPSX), DFA Municipal Bond (DFMPX), and DFA Intermediate Gov’t Fixed Income (DFIGX). Past performance does not guarantee future results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Mentions of specific securities should not be construed as a recommendation. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this document. R-22-4451