Higher interest rates have been expected for months – the Federal Reserve has consistently signaled that. But inflation came in higher than expected late last week at +8.6% annually for the CPI. A little moderation had been anticipated, yet this was the highest yearly change of this cycle and the largest jump in the inflation index since 1981. That spooked markets and prompted adjustments to expectations for rate increases: perhaps those increases would now come higher and faster than had been expected before.
Moreover, there is always a significant risk that interest rate hikes could cause a recession and most consider that risk is lower if the Fed moves slowly and heightened if it moves quickly, so the ugly inflation report also raised the perceived risk of recession.
Stocks reacted by giving up May gains and slipping into a bear market – down more than 20% from their early January high.
This week, the Federal Reserve raised short-term interest rates by 0.75%, signaled higher, faster increases to come, and strengthened its language on inflation. Stocks initially moved up in approval, but then fell to new lows for the cycle.
How does a bear market impact long-term investors? Future returns for stocks and bonds over any period are highly dependent upon starting valuations. Other things being equal, lower valuations for stocks and higher yields for bonds imply higher expected and actual long-term returns from here than otherwise. If a recession is also added to the mix, that will depress earnings, resulting in lower expected future returns for stocks in the near term, but that typically has little bearing on expected long-term returns either.
Stock market declines of 20% and more are no fun, but it is a fact of investing that they do occur from time to time. Some keep going and ultimately turn into larger market declines of 30% or 40% or more. Others stop barely into bear market territory and then turn up.
We don’t know which path the current bear market is most likely to take. There are certainly plenty of extreme crosscurrents pulling both ways now. We are experiencing the first global pandemic in 100 years, the largest war in Europe in 75 years, the worst inflation in 40 years, and consumer sentiment just hit a record low. On the other hand, corporate profits and stock earnings have been strong, consumer balance sheets remain quite strong, Pandemic reopening continues, May unemployment remained at a low 3.6%, and in the US, there are almost twice as many unfilled positions as there are unemployed adults. So far, the economy has remained strong in the face of higher inflation and higher interest rates, but that could change quickly.
We’ve often said most investors worry too much about things they can’t control, such as where the market is headed, and too little about those things they can, such as limiting taxes and other costs, assuring portfolios are well-diversified and represent better valuation than the overall market, and holding the right stock allocation for their circumstances. That is particularly true in bear markets. Heightened market volatility enhances rebalancing opportunities and market declines often allow us to capture tax losses, so we will clearly focus on those now. But otherwise, bear markets are the test for long-term investors and the occasion where long-term discipline matters most. Dropping discipline and succumbing to the temptation to sell stocks into fear just makes losses permanent, whereas history has always rewarded the disciplined and patient investor with new market highs in time.
“Steady” is the watchword, and “this will pass (eventually)” is the guidance to lean on.