Rates are Rising and the Sky is Falling
If you have been watching markets closely this week, your blood pressure may be a bit higher than normal. Upon the release of the Wednesday’s much-anticipated Federal Reserve policy decision – which played out pretty much exactly as expected with a half-point rate hike, bringing fed funds target to 0.75% to 1.00% – markets rallied into the close. On Thursday, however, the rug was pulled out from under the bulls and stocks endured their steepest sell-off since the Covid-19 plunge in 2020. The S&P 500 has put in a fresh low for the year and is down roughly 14% from its January 3rd peak.

A 14% loss of principal is beyond the comfort level for many; and investors who were misaligned from a risk-tolerance standpoint may be at or near capitulation levels, wondering how much worse the selling will get. However, if we zoom out to view the long-term picture, we observe that this drawdown is very typical, with 14% being the average drawdown going back to 1980. As the chart below (courtesy of JPMorgan’s Guide to the Markets) demonstrates, the S&P has shown resiliency to weather drawdowns far more severe than our current one, and still return positive value by year end.
Exhibit: S&P 500 Maximum Drawdown (red dots) and Calendar Year Returns (grey bars)
Source: JPMorgan Quarterly Guide to the Markets
The distinctive feature of the 2022 drawdown is that the typical safe-haven government bonds are falling alongside equities and in the case of long-term Treasuries have experienced an even steeper drawdown, exceeding 22%. Thus far, the only real hedge that has worked well is energy and commodities, but that trade remains high risk given the ongoing war in Ukraine and the potential for a reduction in demand for fossil fuels if economic growth declines. The synchronized decline in both stocks and bonds has certainly made this year’s “average” drawdown seem more painful, with even the most conservative investors experiencing some degree of losses.

2020’s COVID lows should serve as a recent reminder of how quickly markets can shift from despair to exuberance and drawdowns can be erased. Recall the lows of the COVID shutdowns, as investors braced for the unemployment surge and a presumed deluge of corporate defaults. Once this crisis was averted via Federal Reserve and government intervention, the narrative quickly shifted towards vaccinations and reopening, triggering an epic run in the markets. Presently, the market is under pressure because it doubts that the Federal Reserve can successfully engineer a “soft landing” as it combats inflation via interest rate hikes. Inflation data will determine whether this narrative changes in the coming months, and we expect to see lower headline inflation numbers as some of the large inflation spikes from last year drop off the trailing data. Aside from inflation, many economic indicators, particularly employment data, suggest that the economy may be able to weather the rate hike shock without slipping into a recession.  If that scenario plays out, expect the market to quickly forget the drawdown, and have less downside and even rally in Q4 after the midterm elections.
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