With stocks in a bear market, inflation on the rise, and concerns growing over the possibility of a recession, David Royal, Thrivent Chief Investment Officer, and Steve Lowe, Chief Investment Strategist, recently offered their assessment of the challenges facing the markets and the economy.

Inflation

Rising inflation caught the Federal Reserve (Fed) off guard, and it was slow to respond as signs of inflation began to surface.

“A year ago, the Fed expected no rate hikes until 2024,” explained Lowe. But even after inflation began to take hold, the Fed was slow to gauge how rapidly the cost of goods and services would rise. “The Fed made a mistake. They thought inflation was going to be transitory, which it was not. They reacted way too late, so now we have inflation that’s the highest in 40 years.”

Once the Fed finally stepped in to combat inflation by raising rates and tightening the money supply, its actions caused both the bond and stock markets to tank. It has also led to an inversion of the yield curve, with shorter term bonds paying higher yields than long-term bonds.

While inflation, rising interest rates, and an inversion of the yield curve are often precursors to a recession, Royal and Lowe don’t believe that is a foregone conclusion. They pointed out that household balance sheets are solid, employment is strong, corporate earnings are good, and there are no large structural imbalances in the economy.

A combination of unforeseen factors led to inflation and the flagging economy. The Covid-19 pandemic, supply chain issues, a very accommodating Fed policy, billions of dollars in stimulus payments, and the Russian invasion of Ukraine have all been shocks to the economy. “This was a period of unprecedented developments,” explained Royal. “They weren’t the type of fiscal or monetary actions you would see in a normal economic cycle.”

When will inflation begin to decline? “Our expectation is we’ll reach a peak in inflation later this year,” said Lowe. “We’re seeing it gradually slow down, but the wild card is commodity prices. That’s what’s holding the economy hostage. Fuel prices will be a big factor, and food is the other issue because Ukraine and Russia had been major food suppliers.”

Recession

Are we headed for a recession? “Projections for a recession have been all over the map,” explained Lowe. “The median range of projections has been about a 30 to 50% probability, but I think it’s at the lower end of that.”

Royal and Lowe point to the strong consumer and business balance sheets, rising corporate earnings, and full employment as reasons for optimism.

“Earnings surprises have been very strong all year,” noted Lowe. As a result, he expects that stocks may perform better than many market analysts have projected.

He also pointed out that stock valuations, which had been relatively high, have fallen during the recent market sell-off, and are now in a more normal range.

Market recovery

“Duration of a bear market tends to be much shorter if you don’t go into recession,” explained Royal. “Average performance once you reach a bear market has been pretty good over the following 12 months, and the loss probability is fairly low.

“If you are underweight equity, as the markets decline, if you keep rebalancing your portfolio that should be effective over the long term,” he added. “Some of the biggest upward rallies tend to be during bear markets. You want to be there when those rallies happen.”

Volatility

“This is a period when good news can be seen as bad news,” said Royal. For instance, a strong employment report can stoke fears that the Fed will take more aggressive action to raise rates. “As a result, stocks go down. Then you get some bad news, either some weak economic news or the mere decline in stocks, and then paradoxically investors get more optimistic that we’re going to have a soft landing, and stocks go up, and we keep repeating this cycle.

“As this continues,” he adds, “we’re going to see continued volatility, with this back and forth between growth and value, as we’ve seen the past couple of months. One day the NASDAQ is up, the next day energy is up, and stocks are down. There’s this constant trade-off.”

When will volatility subside?

“When will this all stop? I think it’s going to stop when inflation – even if it’s still high – is under control,” explained Royal. “The Fed is going to be hawkish for a while, but I believe once the market believes that the Fed actually has started to get inflation under control, we’re going to start to see good news be good news and bad news be bad news again. That’s going to be the indicator that we’re back onto this economic cycle. And then I do think we’re going to have the opportunity to see some quality growth names rebound.”

In the meantime, consumers remain nervous over rising costs for food and other goods and services – and $5 per gallon gasoline. “In the lower income segments, gas prices matter more,” said Lowe. “We’re also seeing credit card balances rise for the first time in quite a while, which, again, affects the lower income part of the economy. But most people are still relatively healthy financially.”

Interest rates

With interest rates on the rise, how should fixed income investors approach the market?

“One area I like now is municipal bonds,” said Royal. “Right now, their yields look good relative to taxable issues.”

“I feel very comfortable with munis right now,” agreed Lowe. “It would take a very deep recession to affect municipal bonds; they’re a very high-quality asset class.”

In slow economic times, high yield bonds can face the possibility of default, but Lowe doesn’t consider that to be pressing issue in the current environment. “Defaults are a lagging indicator. By the time we see a lot of defaults, we’re usually at the end of a recession. At the present time, defaults are near record lows. We’ll probably see that tick up a little bit, but I don’t expect much of a problem with defaults.”

Royal sees some positives in the rising rates. “Net-net, I’d rather have a 10-year treasury at 3.5% rather than 1.5%. And all things being equal, higher rates are better for financial companies. Rising rates will make the company’s finances stronger.”

Real estate

With mortgages rates rising, the housing market is cooling off, but Royal sees some promising areas in the real estate market. “We’re underweight office space, but we’re overweight in areas like industrial, warehouses, and multi-family, so I think these will be some of the sectors that are less affected by the rising rates.

“My bigger concern,” he added, “would be around warehousing, although it has done pretty well so far. We feel quite good about real estate, and we’re actually growing our real estate equity portfolio.”

Asset allocation

How has the current economic environment affected asset allocation at Thrivent? “We’re close to our normal allocation,” said Lowe. “We’re modestly overweight equities, and overweight domestic. Once we feel comfortable that inflation is near the peak, we’ll add some risk (with more equities). Domestically, small caps are getting interesting, but we’d like to see them come down a little more.”

“I wouldn’t be a seller of equities now,” added Royal. “Growth is getting cheaper. There are some great quality companies with strong earnings growth rates that are down 50%. I personally like the small and mid-cap growth space that have been hit the hardest. Maybe I’d go with mid-cap first since it is a little less risky in this environment. I also like the large cap growth space, and some of the big tech names.”

Lowe believes the market could go lower if the economy goes into recession, but he still cautions investors against selling stocks at this point. “A lot of it depends on your investment horizon. We’re at levels now where the probability of long-term gains is quite high.”