The calm in the eye of the storm

Coming up, the recent market rally, what it means, and the opportunities that it brings.

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From Thrivent Asset Management, welcome to episode 35 of Advisor’s Market360^™. A podcast for you, the driven financial advisor.

The tumultuous storm that sustained through the first half of the year and shook the world’s capital markets has led to a break from the chaos. Over the past month or so, both stock and bond markets have enjoyed recoveries. Does this mean that the storm has ended, or is it just a temporary “bear market rally” – the proverbial eye of the storm? At the same time, the word “recession” is getting a lot of use. So, we have to ask: how much does all of it matter?

For long-term investors, this moment of peace presents an opportunity to ease the tension, set aside the emotions of the past, and take a clear-eyed look at the current environment. Has the storm left your portfolio scattered and unbalanced? Now may offer a chance to seek out what opportunities exist in the here-and-now.

Listen on to hear Thrivent’s up-to-date take on the current economic environment. We’ll compare this year to historical bear markets and recessions, offer our views on what may come next, and, of course, discuss the opportunities we see in today’s market.

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First, let’s talk about recession. The U.S. economy has now registered two consecutive quarters of negative growth of gross domestic product, or GDP. Historically, this has been the rule of thumb for establishing that a recession has commenced. However, other criteria matter too, such as income and the job market. With job and wage growth continuing, and with unemployment at an exceptionally low level of 3.6%, this certainly doesn’t look like past recessions.

Regardless of the technical definition of a recession, indicators such as housing starts, rising inventories, and slowing orders clearly point to a weakening economy. On the flip side, there’s a strong job market, bolstered consumer spending, a balanced economy, and a healthy banking system. So, if this is a recession, then so far it appears to be a relatively shallow and mild one.

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Now, for inflation. After acknowledging their mistake in underestimating the risk of inflation, the Federal Reserve, or Fed, has pivoted to a policy of combatting high inflation with aggressive increases in interest rates. As of now, there has been little evidence that inflation is broadly moderating, with the exception lying in the commodity markets. However, the bond market seems to be factoring in the probability that the Fed will be successful in bringing down inflation, along with moderating demand, as inflation erodes consumers’ buying power.

Since the end of the second quarter, longer bond yields are down significantly, although money market yields, or short Treasury bills, are up sharply due to Fed rate hikes. This has led to a very flat-to-inverted yield curve.

With Treasury bond yields below 3% and inflation at about 9% based on the Consumer Price Index, or CPI, investing in safe, long-maturity Treasury bonds is a bet that inflation will decline more sharply over time. The odds of that bet paying off in the near term seems slim at the moment, with such high inflation numbers still being reported.

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Next, let’s take a look at corporate earnings, valuations, and credit spreads. Corporations have had to deal with the significant challenges of supply chain disruptions, rising commodity and labor costs, higher interest rates, a historically high U.S. dollar – which cuts into international profits – and rapidly changing consumer demand. These issues have impacted various industries and companies differently, leading to wide variations in earnings. Energy companies have reported record profits, while retailers and some industrial companies have reported disappointing results due to excessive inventories and labor costs. In short, corporate earnings reports for the second quarter have been mixed, but mostly better than expected with little evidence of a sharp overall decline in profits.

The price-to-earnings, or P/E, ratio, a standard valuation metric for stocks, has declined meaningfully from the exuberant levels it reached last year. Currently, valuation using this simple metric is roughly in line with long-term averages. But earnings clarity going forward remains muddled given the many challenges facing corporate management teams.

Valuation measures are a rather poor indicator for potential short-term market direction. So, although stock prices have collectively and significantly declined, the market as a whole is not cheap by historical standards.

These challenges have combined to push up the yield on corporate bonds to levels that investors demand for taking on this type of credit risk. Credit spreads have widened dramatically throughout 2022 as investors have become increasingly concerned about the prospect of a protracted recession leading to higher default rates.

This widening in credit spreads, coupled with higher interest rates, has led to bond yields in various non-Treasury sectors that have not been seen in years. For yield-oriented income investors, valuation in the credit sectors of the bond market does seem attractive on a risk-adjusted basis, particularly in BBB-rated, high yield, and securitized bonds. Certain sectors of the municipal market also seem relatively attractive, but only for higher tax bracket individuals. However, the municipal bond market, with its longer duration, may be more susceptible to rising interest rates.

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In other markets: the S&P 500® index, which tracks the average performance of 500 U.S. large-cap stocks, staged a sharp rally in July – up over 9% after having suffered a significant decline through the first half of the year. This coincided almost exactly with a sharp rally in the bond market, with longer maturity yields falling about 50 basis points and aggregate bond indexes rising 5%.

Value-oriented stocks, especially those with meaningful dividend payouts, were stalwart performers in the equity market. Investors had gravitated to income-oriented opportunities which are typically seen as relatively safe during rising rate environments. But, as long-term interest rates declined, growth stocks snapped back in terms of relative performance, outperforming the value segment by approximately 8% in July.

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As one would expect, there are numbers and statistics involved in defining an “economic recession” and a “bear market.” But both are also subjective. Currently, as we consider these terms, the environment we’re in is rather ambiguous. Technically speaking, the formal criteria for each has been achieved. And, as mentioned previously, if the economy is in a recession, as of now, it appears to be fairly mild. The equity market certainly approached what could be defined as a bear market, but the recent strong market rally has led to the question of whether bear market conditions persist.

Historically, it’s been common to see rallies of 10%, 20% or more in the midst of bear markets. Considering those in 2000 and 2008, substantial bear market rallies were followed by sharp declines. However, the environment surrounding those past bear markets was decidedly different than the environment today.

For example, in 2000, the market was flushing out all the unprofitable Dot Com technology stocks. But today’s technology sector is far more profitable, stable and a key cornerstone of the U.S. economy. After suffering significant price declines recently, valuation in this dynamic sector is relatively attractive from a historical standpoint.

The Great Financial Crisis of 2008 that led to huge stock market declines was precipitated by a housing and banking crisis that was systemic to the integrity of the entire financial system. Today, the banking system is quite healthy, and the housing market has been incredibly strong. Granted, it has weakened recently due to the rise in mortgage rates.

As for the relatively new and notorious cryptocurrency space, the damage has been severe. However, there isn’t much of a threat to traditional, closely regulated financial institutions.

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Right now, overall market volatility is due to several factors: one, the markets are continuing to adapt to a post-Covid reality with its secular impacts; two, the Fed’s shift in policy away from its zero interest rates and bond-buying approach; and three, the impact of the tragic and economically disruptive war in Europe.

It wouldn’t be surprising if both the stock and bond markets give back some of the strong price moves of the past month or so, especially since there’s still uncertainty over inflation, interest rates, corporate profitability, and the economy. However, trying to time the bottom in a bear market is a fool’s errand. Bear markets do matter, but for long-term investors, they should be viewed as something to take advantage of, not feared.

Currently, there are opportunities in the credit markets for income-oriented investors to book yields that are now 4–8%, depending on quality and term to maturity. It has been quite some time since yields have been this high, even though inflation will detract somewhat from “real” returns.

After such a strong rally in the equity markets, long-term valuation now seems more reasonable – despite the near-term having become less compelling. Valuation in small-cap U.S. stocks versus large caps appears quite attractive from a long-term perspective. But, as always, patience may be required, given that smaller companies tend to perform better once a new economic expansion begins.

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Thanks for listening to this episode of Advisor’s Market360^™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. We’d like to hear from you! If you’ve got questions or comments about this episode, or if you have an idea for a topic, email us at podcast@thriventfunds.com. You can also learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.

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All information and representations herein are as of August 2, 2022, unless otherwise noted.

Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Any indexes discussed are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Past performance is not necessarily indicative of future results.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.