Stock

How far will the market correction go?

Key takeaways

  • U.S. stocks experienced a bear market (a decline of 20% or more in value) in 2022.
  • Persistently higher inflation and other concerns raised investor anxiety in the first half of 2022.
  • Investors are watching for signs of a potential turnaround.

U.S. stocks, as measured by the benchmark S&P 500 index, officially fell into “bear market” territory in June 2022. This represents a decline that exceeds 20% of the peak value of the index. Such setbacks occur periodically in the markets. The technology-heavy NASDAQ Composite Index (which includes about 3,000 common equities) and the Russell 2000 Index of small-cap stocks both dropped into bear market status earlier in the year.

Stock market downturns such as these occur for various reasons. Sometimes the changes are related to excessive market valuations after an extended bull market. In other cases, they may be due to external events that overshadow other fundamental factors that typically drive stock market performance.

“The most recent downturn can be attributed to the level of uncertainty the market sees,” says Rob Haworth, senior investment strategy director at U.S. Bank. Several events contributed to the environment, including persistently high inflation, a dramatic change in monetary policy by the Federal Reserve and the economic fallout from Russia’s invasion of Ukraine.

Tracking previous market declines

Explanations for most serious market downturns are typically easier to come by after the fact. Consider some recent examples.

In early 2000, an extended bear market began that persisted until early 2003, on the heels of a long-lasting bull market. The most notable driver of this significant setback for equity prices was the bursting of a stock market “bubble” in prices for technology stocks, particularly some early-stage dot-com companies.

The 2007 to 2009 bear market was driven in large part by a surge in home prices that proved to be unsustainable. Too many property owners were highly leveraged, and not capable of sustaining the mortgages they obtained. This easy credit environment created problems throughout the financial system that required significant government intervention.

In February and March 2020, investors were just beginning to come to grips with the reality of the COVID-19 pandemic. Concerns about the unknown ramifications to the economy caused investors to temporarily lose confidence in stocks. That downturn was short-lived, and those who remained invested in stocks prospered through much of 2020 and throughout 2021.

“In today’s market, we’ve seen a massive change in sentiment,” says Haworth. The persistent nature of an elevated inflation rate appears to be a key cause of investor anxiety. Higher inflation is a result of demand for goods and services outpacing supply. Haworth believes this will continue to create challenges for the economy. “Supply constraints that initially led to some of the inflationary issues are not fully resolved. At the same time, neither consumers nor businesses are cutting back on spending.” Russia’s war with Ukraine is also contributing to inflation pressures, particularly in relation to the food and energy sectors.

“Inflation falters if demand drops off, but there’s still quite a lot of pent-up demand,” says Haworth. This is what the Federal Reserve (the Fed) is attempting to slow through multiple policy actions, including a significant hike in the short-term federal funds rate. The Fed is trying to slow the economy sufficiently to temper inflation while trying to avoid a recession.

The Fed’s focus on slower economic growth

After the economy as measured by Gross Domestic Product (GDP) grew at a rate of 5.7% in 2021 (the fastest annual rate of growth since 1984), the pace slowed in early 2022. In the first quarter of the year, GDP declined by 1.5%.1 The sudden negative turn may have surprised some, but it reflected certain anomalies in the data used to calculate GDP in the first three months of the year. Despite the negative reading, consumer spending continued to grow in the first quarter. Nevertheless, the data reflects a reality in 2022. “We believe that the rate of economic growth will slow over the course of the year,” says Haworth “though it is not inevitable that we’re headed for a recession.” (A recession is defined as two consecutive quarters of negative GDP growth.) The Fed’s shift in monetary policy is intended to slow the economy as a way to temper the inflation threat, but without pushing the nation into a recession. Haworth notes that the Fed began this process with the economy in a reasonably strong position. “Solid economic underpinnings put us in different place than was the case during other bear markets from a fundamental perspective,” says Haworth. “There’s high employment and demand for workers, wages are still rising, consumer balance sheets are strong, debt loads are reasonable and savings balances are not yet being depleted in any significant way.”

From an economic perspective, Haworth believes this is important because it puts consumers in a reasonable position to weather any short-term impacts from current global instability. This includes factors such as higher energy prices and rising interest rates. He notes that energy price spikes often have a short-term impact on spending sentiment, but that consumers are in a stronger position today, which may limit the negative effects of higher gas prices.

When will stocks become “oversold?”

While external events had a major impact on stock market performance in the first half of 2022, market fundamentals, such as corporate revenue and earnings, will likely be the biggest factors that affect stock prices for the long run. “Earnings in the first quarter were slightly ahead of expectations,” says Haworth. “and the general outlook for earnings has been upgraded as we look ahead to the rest of 2022.” That could change, depending on a number of variables, including the impact of the Federal Reserve’s measures aimed at slowing the economy and the continued impact of inflation. “Companies have been able to maintain earnings levels to date because they could push through price increases,” says Haworth. “Can they continue to do that? It will tell us a lot about how earnings hold up through the year.”

Eric Freedman, chief investment officer at U.S. Bank, says it’s important to maintain an appropriate perspective about the environment. He cautions that markets are likely to continue to be volatile. Nevertheless, he urges investors to maintain a long-term perspective. “Timing the markets and trying to be precise on when to be in and when to be out is challenging,” says Freedman. “Markets will do things at the exact opposite time you expect them to.”

“Keep in mind that we’re likely to experience market ups and downs regardless, and over time, markets have shown an ability to recover.”

– Rob Haworth, senior investment strategist, U.S. Bank Wealth Management

Freedman notes that investors experienced an unusual phenomenon in the opening months of 2022, as both stocks and bonds suffered simultaneous setbacks. It was a rare example when diversifying a portfolio using a mix of stocks and bonds did not prove to be an effective strategy to offset market volatility. “That’s unusual to see, and it is only a short-term phenomenon, but we will reach a point of stability,” says Freedman. “Markets will find a level where the environment begins to improve. It’s not the most enjoyable process in the meantime, but this too shall pass.”

Key factors to watch

What are the critical factors at play that could impact the timing of a turnaround in the markets?

  • Inflation. “Inflation concerns remain near the top of the list,” says Freedman. “Inflation is proving more persistent than initially anticipated.” Notably, Fed Chairman Jerome Powell has proclaimed that “inflation is much too high.”2 Recent inflation data seems to confirm his stance. The change in the cost-of-living for the 12 months ending in May, 2022 was 8.6%, the highest in four decades. Yet Freedman believes it’s plausible that inflation will begin to subside rather than to keep rising over the course of the year, though there are a number of variables that could impact the trend.
  • Fed monetary policy. In response to the inflation threat, the Fed announced more significant steps to tighten monetary policy. It ended its quantitative easing program in March. The program involved purchases of $120 billion in Treasury and mortgage-backed bonds per month dating back to early 2020, a strategy that was designed to help maintain liquidity in the market and keep interest rates lower. It is just beginning to scale back its existing bond holdings, a step it hasn’t taken in more than two years. This could put upward pressure on yields for Treasury bonds and mortgage-backed securities. In fact, yields on the 10-year U.S. Treasury reached their highest point in 11 years in mid-June. The Fed also moved off of its zero-interest rate policy on the short-term target federal funds rate, raising rates by 1.50% between March and June. “Market expectations now are for additional interest rate hikes in 2022 with the likelihood of more in 2023,” says Haworth. Chairman Powell has made clear the Fed is determined to subdue inflation. “Markets may be tested if it appears the Fed is getting ahead of itself and taking too aggressive a stance with its tightening policies,” says Freedman. The conflict in Ukraine and the economic ramifications from it (such as higher energy prices that occurred in the months following the invasion) may require more of a balancing act by the Fed. It could complicate the Fed’s efforts to raise interest rates at a pace that slows the economy, but avoids a recession.
  • Consumer spending. Consumer spending is a major driver of economic growth. “While the Fed tries to get a handle on inflation, another of its objectives is to maintain maximum employment’ in the economy,” says Haworth. While not measured by a specific employment statistic, “maximum employment” is a subjective assessment made by the Fed. “The Fed has made clear its first target is to soften inflation. It will take a softening labor market to accomplish that,” says Haworth. That could eventually be translated into a slowdown in consumer spending. The resulting impact on corporate profits will be an important factor to watch.
  • COVID-19. The virus that was so disruptive in recent years has become more part of our everyday lives, but not yet a thing of the past. “We reopened more, with people heading back to offices and more activity occurring, which is supportive of economic growth,” says Haworth. Yet some caution remains as COVID infection rates remain stubbornly high and pockets around the world experienced significant increases in COVID numbers.
  • The impact of the Russia-Ukraine war. One of the most unpredictable variables is the war in Eastern Europe with economic sanctions acting as a primary weapon used by western nations opposed to Russia’s actions, it remains to be seen what the long-term global impact could be. Higher commodity prices are another consequence of the war, which also could dampen global economic growth. Much may depend on how long hostilities persist and whether the conflict spreads to other countries.

Keep a proper perspective

It’s important to remember that frequent market corrections are a normal event. “Keep in mind that we’re likely to experience market ups and downs regardless, and over time, markets have shown an ability to recover,” says Haworth.

Freedman adds that it’s important to have a plan in place that helps inform your investment decision-making. “That’s the foundation of investing,” says Freedman.

Check in with your wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your long-term financial goals.

Diversification and asset allocation do not guarantee returns or protect against losses.

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