Market Volatility & Economic Challenges: Where are We? What’s Next?

Investors know that markets are uncertain, cyclical, and sometimes volatile. However, that knowledge doesn’t always make economic challenges and market downturns easier to endure. While consumers are feeling the effects of inflation on their wallets, recent market declines and economic data reports have caused concern and discomfort for investors. The following questions and answers are meant to help you understand what has happened, how it affects you, and what we anticipate could happen in the future.

What has happened in the investment markets and why?

So far this year, most stock and bond markets have significantly declined in value. Broad U.S. and international stock markets are in a bear market with declines of more than 20% (as of 9/29/22). Although it is impossible to say precisely what causes stock market declines, factors this year have included the war in Ukraine, supply chain challenges, high and persistent levels of inflation, and the U.S. Federal Reserve (Fed) raising interest rates at the fastest pace in history.

The broad bond market has also declined about 14% so far in 2022 primarily driven by the Fed’s increase in interest rates, along with its communication about future rate increases. The level of this decline is well beyond normal bond market activity in any given year and especially surprising given that stocks and bonds don’t usually rise or fall in the same direction simultaneously.

How does inflation affect me and my investments? Why does the Fed need to raise interest rates to fight inflation?

Inflation leads to rising prices and a loss of purchasing power. In other words, you can’t buy as much as you used to with the same amount of money. For you this might mean that the price of your next car, your child’s education, gasoline, and groceries have all risen more than you were expecting and now you can’t buy everything you used to. Low and stable levels of inflation, around 2%, are usually good for the economy and investments because it helps to keep prices stable, businesses profitable, and leads to wage increases. However, excessive inflation can negatively impact the economy and your investments because consumers may eventually spend less and businesses could reduce activity thus becoming less profitable, which all translates into lower economic growth.

You have probably heard inflation defined as “too much money chasing too few goods.” An unprecedented amount of money was injected into the economy after the COVID-19 global pandemic to try and jump-start the economy. However, that stimulus is largely contributing to the high levels of inflation we’re currently seeing. Therefore, the Fed is trying to pull some of that money out of the economy by raising interest rates. As interest rates rise, the cost of borrowing money increases, so fewer individuals and businesses take out loans and liquidity is pulled out of the economy. The Fed hopes that making money less available will lower demand, and therefore, reduce inflation.

Did we know at the start of this year that high inflation would require the Fed to hike interest rates? What did Blue Trust do to protect their clients’ portfolios from losses?

In December of 2021, the Fed forecasted that inflation would cool significantly in 2022, almost reaching its 2% target. Accordingly, the Fed projected that they would raise the target range for the Fed funds rate from 0.00-0.25% to 0.75-1.00% by December 2022. At the time, investors shared that expectation. Since then, several factors have caused inflation to remain stubbornly high, including the Russian invasion, labor shortages, pent-up spending fueled by excess fiscal stimulus, and ongoing COVID-related effects on demand and supply. As inflation has proven to be more persistent than anticipated and the Fed’s attitude toward inflation has become more aggressive, investors’ interest rate expectations have steadily risen. (The market now expects the Fed funds rate to reach 4.25-4.50% in December.) As the market has priced in increasingly higher rates, stocks and bonds have suffered as a result.

At Blue Trust, we believe preparing for a range of potential scenarios is better than attempting to time the market. Thus, before inflation was even a concern, we prepared portfolios for the possibility of high inflation by including diversifying assets such as Treasury Inflation-Protected Securities (TIPS) and absolute return strategies. Throughout this year, we have also maintained less interest rate risk relative to the broad bond market. However, we have not abandoned bonds altogether, as we always seek to keep portfolios positioned for a range of future outcomes and keep risk levels consistent with an intermediate-term time horizon.

In this high inflation environment, can bonds keep up with inflation? Will bonds recover this year’s losses?

In the short-term, bond returns may fail to keep up with inflation as inflation remains high relative to bond yields. Generally, however, investors shouldn’t evaluate bonds over short time periods. Due to the extended length of time that bonds generate cash flows, bonds have had negative returns one out of every 10 years and have failed to keep pace with inflation one out of every three years. However, over a five-year time frame, bonds have more consistently had a positive return and exceeded inflation (see table below).¹

	Negative Returns (% of time)	Trailed Inflation (% of time)
One-year periods	10.0%	33.8%
Five-year periods	0.0%	25.8%

 

Even still, over some five-year periods bonds struggle to keep pace with inflation. This trend is why it’s important to consider whether augmenting a bond portfolio with alternatives—such as commodities, gold, private credit, and absolute return strategies—could improve the chance of meeting your goals. Considering how anomalous the past year has been, it’s unlikely that bonds will return enough over the next four years to catch up to inflation. Due to extremely low beginning yields and a surge in interest rates, as of the end of August, bonds suffered their worst one-year return ever.

However, looking forward bonds appear much more attractive. Due to the Fed’s firm commitment to combat inflation by hiking interest rates, bond yields have risen to 4.86% and five-year inflation expectations have declined to just 2.35% (as of 9/27/22), making it likely that bonds will outpace inflation over the next five years.

Investors know that stock market declines and volatility are inevitable but why does it feel different this time?

While the result of each stock market decline is typically similar, each one feels unique from others because there is a sense of uncertainty and fear about how this one may be different. The potential causes for any given decline, as well as the possible outcomes, do not exactly match declines we have experienced before. It is important to acknowledge this reality and be aware of how it can impact our thinking and behavior. However, it is unwise to allow these thoughts and fears to impact our investing and make quick decisions that could impact our future.

How long will this stock market decline last and how bad will it get?

We can say with confidence that we don’t know. We can also say with certainty that neither does anyone else! There is a very short list of future financial events that we can anticipate (i.e., the timing of companies announcing their earnings or scheduled law changes). However, the list of future events that we cannot predict is endless. To compound the issue, how markets will respond to these events is also unknown. This high degree of uncertainty is not a flaw but a foundational characteristic of stock markets. In fact, it is largely this uncertainty that allows the price of investments to lead to more attractive returns longer term. Instead of fearing, avoiding, or guessing these unknowns, our approach is to help you have an investment plan that incorporates them and even tries to take advantage of them.

What would it take for the market to turn around? What signs of recovery should I watch for?

We don’t know when the market will turn around, no one does. However, there are some metrics we’re watching closely. First is inflation. The market is undoubtedly hoping to see inflation come down closer to the Fed’s target of 2%. Second, we are looking at interest rates. If inflation comes down as desired, the Fed will most likely pause interest rate hikes, or even lower rates, which would give investors peace of mind. Third, is the unemployment level. If inflation and interest rates are lowered without sending unemployment significantly higher, then the market would most likely respond favorably. Two other events that would favorably impact the market, but are highly uncertain, are the ending of the Russia/Ukraine war and the shift away from COVID shutdowns, which continue to cause supply chain disruptions and decrease productivity.

How does Blue Trust view the current market environment? Are you doing anything differently with your clients’ investments?

No one wants to see account values go down. We understand the stress it can cause for investors and their families. We are not surprised by challenging markets, however, and we expect them to occur periodically. Although unsettling, they do not rattle us or cause us concern about our clients’ long-term financial well-being. We work hard to help our clients create a sound financial plan that should be resilient and capable of withstanding the inevitable ups and downs of investment markets. Our team of investment strategists continuously looks for opportunities to take advantage of areas in the markets that may be mispriced or otherwise present attractive return options. We also diversify portfolios to prepare for economic storms such as this one.

In taxable investment accounts, we strategically look to capture capital losses that can reduce taxes as we update our clients’ portfolios. We also continue to monitor the appropriateness of the amount of assets clients have in each of their investment buckets (short-, intermediate-, and long-term). If investors need cash now from their portfolio that exceeds the amount in their short-term bucket, then we will judiciously consider how to generate that cash by looking to sell pockets of their portfolio that either have not declined or have not declined as much. If investors have excess cash that they do not need in the next several years, we encourage them to continue investing that cash according to their financial plan.

Should I worry about my investments?

One of the benefits of having an investment plan is that it allows you not to worry about your investments when market declines inevitably occur. We align our clients’ plans with the anticipated time frame of when they will need money from their investments to meet their goals. This approach means investing money that they may need in the short term (next one to two years) in money market funds and high-quality, short-term bonds; in the intermediate term (three to nine years from now) primarily in bond funds; and for the long term (ten years and beyond) primarily in stock funds. By following this time-based approach with our clients’ investments, they do not need to focus on or worry about short-term stock market declines because the cash needed for their immediate needs has been set aside, and they can leave their investments in the market to recover from short-term declines. Declines in stock markets also create opportunities to invest additional money at more attractive prices and to reposition existing holdings to market segments that have declined more significantly, which may provide options for better long-term returns.

What should I do next?

If you were proactive and have a sound plan in place, you have the freedom not to react in the face of declining investment markets. Our experience has shown that the behavior of an investor is just as important to their long-term results as the behavior of the investment markets. We strongly believe that sticking to your investment plan as markets experience periods of turmoil will bear fruit for you long-term.

From a practical standpoint, we would encourage you not to look at your accounts more often than needed for prudent oversight. You can think of your portfolio like a garden or crop—the leaves may not look great following the recent storm, but you know the root structure is healthy and the soil is good. If you can avoid disturbing your portfolio too much, we believe it will produce reasonable returns over time. We would also urge you to be wary of predictions about the future, especially as the confidence and boldness of those predictions increases.

Finally, please reach out to us if you have additional questions or concerns. At Blue Trust, we strive to understand our clients’ goals and implement a personalized investment strategy to achieve those goals. If you need assistance and would like to talk to a Blue Trust advisor, please contact us at 800.987.2987 or email blog@bluetrust.com.

¹ Based on rolling returns from Dec 1925 – Aug 2022 for the Bloomberg U.S. Aggregate Bond Index (1976-2022) and Ibbotson 5-Year U.S. Government Bonds (1926-1975)

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