- Despite the recent volatility, the US economy is still in an expansion and positioned for further growth.
- Signs of mid-cycle expansion include strong corporate profits and consumer spending, low inventory levels, and a healthy job market.
- We have taken steps to reduce risk in our client accounts, including a gradual reduction in exposure to stocks, and adding inflation hedges.
With both stocks and bonds experiencing notable volatility so far this year, many investors may be feeling anxious. Despite recent market volatility and some outstanding concerns, the investment team at Strategic Advisers believes the US economy is still showing signs of strength. Therefore, we remain positioned for economic growth. However, we have repositioned most well-diversified client accounts, gradually reducing the level of risk and increasing exposure to inflation protection, to account for a more mature phase of the current economic expansion.
Key market challenges
So far this year, markets have been digesting several challenges, including:
- High inflation
- A sharp rise in interest rates, in response to the US Federal Reserve's (the Fed) plan to combat inflation
- Disruptions to global supply chains stemming from the Russia-Ukraine war and COVID challenges in China
We believe these issues have driven most of the market volatility in 2022.
Signs of a maturing US mid-cycle expansion
While these concerns have dominated news headlines, our approach to managing client accounts relies on the US business cycle as the primary driver of our investment decisions. From this perspective, we continue to see numerous signs of a maturing US mid-cycle expansion:
- Corporate profits for the first quarter have come in stronger than expected so far, and expectations for full-year 2022 earnings are drifting higher.
- Consumer spending remains strong, despite rising prices stemming from inflation.
- Many US consumers have higher checking account balances, investment account values, and home values than they did prior to the 2020 pandemic.
- Inventory levels remain low, which is prompting manufacturers to ramp up production and hire workers.
- The job market remains healthy due to strong demand for goods and services.
- Wages are rising across wide swaths of the economy.
- While the Fed is likely to raise interest rates several times this year, historically, stocks have experienced gains during rate-hike cycles as the economy continues to grow.
- Inflation may start to drift lower as supply-chain issues continue to improve and the Fed's interest-rate hikes start to make an impact.
Interestingly, we saw somewhat similar market challenges several years ago. In 2018, both stocks and bonds experienced volatility on economic growth concerns, worries about global trade, and rising interest rates. In fact, US stocks sold off by about 18% in the fourth quarter of that year.1 However, at that time, we believed that the US economy was likely to continue growing. Given that economic expansions have generally been good for stocks, we maintained a meaningful allocation to them. As it turned out, by the end of 2019, stocks were up over 25% and bonds gained over 8%.2 That episode can be a helpful reminder that not all market selloffs reflect a meaningful change in the US business cycle.
Current positioning and recent activity of accounts
While no one knows exactly how the current market environment will play out, we continue to use prudence and diligence in the investment decisions we make for our client accounts. For example, even as we currently hold a modest tilt toward stocks instead of bonds, we have taken steps in recent months to help manage risk within well-diversified accounts as the business cycle has matured:
- We have slowly reduced exposure to stocks, as a maturing business cycle has historically led to more bouts of market volatility.
- We have also taken advantage of higher interest rates to add to high-quality bonds, as higher yields may lead to stronger returns from bonds over time, and bonds can generally provide some protection from stock market volatility.
- Also within bonds, we continue to have investments in high-yield bonds, floating-rate bonds and global bonds, as these kinds of bonds have historically performed well in the face of rising US interest rates.
- Additionally, in an effort to provide protection from inflation, we have held positions in commodities, real estate investment trusts (REITs), and US Treasury Inflation-Protected Securities (TIPS) since 2020, as these investments have tended to hold up well during periods of rising inflation.
- Finally, we have rebalanced portfolios to help ensure risk and return potential remains aligned with client goals and preferences and managed for tax efficiency in portfolios where taxes matter.
We know that alarming headlines and day-to-day swings in the markets can be unsettling. That's why we rely on an abundance of resources and decades of investing experience to construct portfolios that are durable enough to handle trying times, but still provide growth potential over the long term. Helping our clients reach their financial goals is our number one priority.
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