The volatility which has dogged financial markets this year continued during May. After a gain of over 4% in the first few trading days, the U.S. stock market declined for several sessions until it was 5.5% below its April closing level. This peak-to-trough swing was nearly 10%, echoing prior drawdowns that occurred in January, February, and April. Additionally, May’s intramonth decline was enough to drag U.S. stocks down about 19% from their early January high, right on the cusp of an official bear market. During the final week of May, some positive corporate results caused a sharp rally to occur, pushing the U.S. stock market almost back to where it began the month. International stocks even managed to increase nearly 1%, while the U.S. bond market logged its first positive monthly return this year, increasing by 0.6%.
Investors’ concerns are centered on inflation and how Federal Reserve actions to contain it may harm the economy and pressure financial asset values. Inflation has been elevated for more than a year, and the Federal Reserve has admitted their prior inaction was a blunder. Taking this into account, the Fed has renewed fervor to raise interest rates and shrink its balance sheet to get inflation under control. In a recent interview, Fed Chairman Powell said the Fed would keep increasing interest rates until they saw inflation coming down in a “convincing way”.
While necessary, the focus on fighting inflation presents a few risks to investors. Theoretically, higher interest rates reduce the relative attractiveness of stocks as bonds look more and more appealing. Admittedly, this effect is hard to observe since it’s one of many drivers of stock returns. Also, when an economy is running too hot, the excess demand creates inflation. The Federal Reserve typically responds by raising interest rates to slow economic activity. If the Fed goes too far with such interest rate increases, it may trigger a recession, which would hurt corporate earnings and ultimately the stock market.
Regardless of the ultimate outcome of Fed policy, investors have already seen an impact in their portfolios. As mentioned previously, the U.S. stock market came very close to a bear market in May and declined over 20% on an intraday basis. The U.S. bond market was also down over 10% before May’s small recovery. With financial markets so sensitive to central bank policies, we don’t think this year’s volatility is behind us.
Nevertheless, history remains on the side of patient investors who can weather market volatility. While the present hasn’t given investors much to celebrate, the long-term investment environment is starting to look better. Bear markets do have their uses and kneading out financial excess is one of them. Especially when you consider the last three years, the price of some stocks got ahead of their earnings. In fact, this year represents the first time in the last three years where forecasts of future returns are trending up. No one enjoys volatility, but it does create potential. Volatility wrings out excess, so the future can be brighter.