While many pundits are trying to gauge the probability of a recession, for public equity investors, what is more important is identifying signs of the bottom in this bear market. Over the past several decades, it was easier to determine signs of a market bottom. The rule of thumb was relatively simple, a 10%-20% shakeout in the equity markets usually led to the US Federal reserve coming to the rescue. Going back to 1987, the Fed always eased aggressively in response to major bear markets. This is what the industry called the “Fed put”. Once the Fed reacted aggressively to bear markets or corrections, it was a signal to “buy the dip”.
Don’t bank on the “Fed put” this time around. Since the 1990s until most recently, the major problem facing policymakers had been low inflation, slow growth, and the ongoing threat of deflation. As a result, the Fed’s policy objective was always focused on protecting economic growth. This is the main reason why the Fed has always been quick to ease monetary policy on the first signs of economic weakness, often led by a falling stock market.
While that had been the case since the late 80’s to more recently, now we must look to the 1970’s for guidance on Fed behaviour. When inflation was high and rising, the Fed often tightened into a falling stock market and recession during this period. As a result, policy was tilted towards fighting inflation, even at the expense of economic growth.
With that as historical context, is there any way that we can determine when a market bottom may be close? While we only know where the bottom is after the fact, there are a couple of things we will keep our eye on that may provide some guidance. A financial “accident” may force the Fed to ease. A financial accident that can have a contagion impact on the global financial system such as the 1998 Asian Financial crisis or the Great Financial Crisis of 2008-2009 would force the Fed to retreat from its current policy of raising rates at the expense of economic growth. Currently, we don’t see any emerging issues on the horizon, but rather a potential recession that could ironically be positive for markets.
Ultimately, the variable that has led us to where we are, is the variable that will also lead to a market bottom. That variable is inflation. While there are no clear signs of inflation pressures receding anytime soon, we do believe that inflation measures may gradually recede over the next few quarters. Oil is already off considerably from its recent high, while food prices such as corn and wheat have also fallen sharply to the tune of 20%-25%. A resolution to the Ukraine war could also be a catalyst for a recovery, however that is speculation at this point.
We suspect that the bar for a more dovish Federal Reserve is relatively high given it misjudged inflation so egregiously over the past two years. If oil and food prices continue to fall, that could force the Fed to pivot to the dovish side and provide a boost to both stocks and bonds. On another note, if a recession does occur, earnings will fall, leading to further stock price declines and receding inflationary pressures, likely causing the Fed to shift from tightening to loosening monetary policy. The bottom line is that falling inflation will represent an improvement in the macroeconomic backdrop and therefore has the potential to help put in a bottom in the current bear market.
As written in past commentaries, since 2021 we have dramatically reduced our public equity allocations to lessen our client’s exposure to short-term market fluctuations. This has worked out very well during this market selloff. While we are not immune to negative portfolio returns, a properly globally diversified portfolio, containing both public and private asset classes across the investable universe will provide you with a superior risk-adjusted return profile. Please contact your Wealth Counsellor if you have any questions.