One of the hardest things to navigate in the sailing world is a shifting of the winds. A myriad of adjustments, which don’t always go smoothly, must be made to the boat’s equipment and direction to successfully navigate toward the destination. In the market, a shifting of the winds causes similar disruption, and the winds are certainly changing. Markets have stumbled out of the gate this year with the S&P 500 down almost 10% at its lows in late January, while the tech-heavy Nasdaq sold off nearly 15%. Bonds have not provided respite either as the broad indexes have lost almost 3.5% this year. Even Bitcoin, the supposed hiding place from fiscal and Federal Reserve shenanigans, was down 25% at its lows and still remains down on the year. Unfortunately, there have not been many places to take shelter so far in 2022.
The market narrative of the post-Covid recovery had been fairly simple until now. Low interest rates, massive Fed and fiscal stimulus, and an earnings rebound from economic re-opening gave a double shot of profit lift and valuation expansion to market returns over the last 2 years. The Covid shutdowns were unprecedented, as were the stimulus response and subsequent recovery. But now we need to deal with the hangover from these market dislocations: inflation.
A stimulus-driven surge in demand combined with supply chain bottlenecks have created an environment of higher and more persistent inflation than many, including the Federal Reserve, expected. And as we’ve discussed in prior pieces, this has forced the Fed to pivot from an economic recovery enabler to an inflation firefighter. The Fed has a very fine needle to thread over the course of the next year or so as they raise rates. If they raise too slowly, they risk inflation staying heated, which would hurt consumer spending power (particularly if wages don’t also rise commensurately). On the flip side, if they move too fast, they risk choking off growth and hurting the stock market through slower growth and lower valuations. The market will be hanging on every word Jerome Powell speaks trying to decipher which way the Fed is leaning. Part of the market weakness to date has been a more hawkish tone from the Fed than expected. In fact, the odds of a March rate hike have gone from 2% last September to 100% today.
In addition to higher interest rates, inflation can also be a corporate earnings headwind. Input costs are rising and companies that have trouble passing these costs along in the form of higher prices will suffer. We are already seeing it in the market as the number of companies revising down their year-end forecasts is almost double the rate of a year ago. This is a marked change compared to the consistently higher earnings revisions we saw in the past few years. This slowdown in growth is to be expected, as in these conditions the market can’t repeat the 40+% earnings growth it achieved in 2021. For context, long-term earnings growth averages around 7%. Some normalization in earnings growth rates and economic growth rates should be expected.
What the market hates most is change. In periods of change fear often takes hold, leading to market volatility. We are in a new investing environment where interest rates, inflation, and earnings have become a potential headwind rather than a tailwind. But just like in sailing, a headwind does not mean we cannot move forward. We just need to make adjustments to the vessel and expect a different pace of progress toward our destination.