Volatility has been a consistent theme this year and September proved no different. Investor optimism carried the global stock market higher during the beginning of September. However, that optimism faded. While inflation dropped from 8.5% in August to 8.3% in September, the Federal Reserve saw the drop as too meager and signaled more interest rate increases on the horizon. Unless October inflation statistics show a more significant drop, the Federal Reserve is expected to follow the September 0.75% rate increase with another in November. In our opinion, the Federal Reserve doesn’t have much of a choice in the matter. High inflation puts a consistently unwanted pressure on consumers and on the economy in general. Raising interest rates is one of the few historically effective ways to thwart this pressure. Rate increases, however, raise the chance of a recession, a possibility now being priced in to the market as illustrated by September’s market drop.
It is very possible the stock market has begun pricing in a recession prematurely. The unemployment rate still sits comfortably under 4%, a remarkable figure considering there are still over 10 million job openings. GDP is projected to grow in 2023 and U.S. companies still show earnings growth. Those are not contractionary signs. Speaking at a recent news conference about increasing interest rates, Chair Jerome Powell said, “No one knows whether this process will lead to a recession or, if so, how significant that recession will be.” His humility on the topic is appropriate given economists’ track record of predicting them. In February of 2019, private-sector economist Andrew Brigden determined that there have been 469 economic downturns since 1988. Of those 469 downturns, the International Monetary Fund (IMF) had predicted only four by the preceding spring. Recessions are hard to predict.
But, as last month’s volatility shows, the market has begun pricing in the possibility of a recession anyway. This is important to investors in a few respects. By the time a recession is known, the market generally has already priced in much of the effects. In other words, because markets are forward-looking and digest bad news quickly, they often decline and recover well ahead of the economy itself. Also, when the guise of recession takes shape, market volatility often ensues, and new opportunities emerge.
Indeed, U.S. small cap stocks, as measured by the S&P 600 small cap index, currently trade at 10.6 forward earnings. They have rarely been cheaper. You have to go back to the peak pessimism during the COVID-19 market panic or to the global financial crisis of 2008 to find a time when they touched this ratio for even a brief period of time. The Fed reversing its easy money policies, which were largely in place during the last 14 years, has caused fixed-income investments to finally provide a meaningful return. A six-month Treasury bill now yields nearly 4%, and a five-year Treasury Inflation-Protected Security held to maturity should deliver a positive return above inflation. More generally with stocks, forward returns have increased and investors can buy U.S. companies at price-to-earnings ratios rarely seen since 2016.
While recessions do eventually reduce corporate profits, they tend to be relatively short-lived events for both the economy and financial markets. The burst in growth that follows also drives stock prices higher. With nearly all major financial institutions still forecasting positive returns for stocks and bonds over the next 5-10 years, patient investors will likely be rewarded, even if the path is a winding one.