Market Outlook April 2022

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The first quarter of 2022 saw inflation risk, interest rate risk, and geopolitical risk rise to the forefront. With the S&P 500 down 5% this year, is this another opportunity to buy the dip or just the beginning of a larger selloff?

Vanguard recently released their 10-year asset return outlooks and projected a rather poor outlook for US stocks. Vanguard expects US large-cap stocks (basically the S&P 500) to earn just 1.9% to 3.9% per year over the next decade. Growth stocks are expected to fare even worse, possibly declining as much as 1.2% per year.

This is a far cry from the 9% to 10% returns that US stocks have averaged over the long run. It stands at an even greater contrast to the more than 16% per year return we enjoyed for the decade ending December 2021. Since history shows that decades of phenomenal stock growth tend to be followed by decades of dismal growth, we should not be too quick to dismiss Vanguard’s forecasts as improbable. Most people know the decade from 1991 to 2000 was a superb period for stocks (annualized return of 15%). We tend to forget that 2001 to 2010 was a lost decade where the S&P 500 only increased 1% per year (including dividends). In this light, Vanguard’s low-single-digit return for the next decade starts to look rather reasonable.  

Vanguard 10-Year Asset Return Outlook (link)

My own outlook for the market is also poor. With rising interest rates and an inverted yield curve, US stocks are likely to face some choppy waters in the coming year or two. First, the pace at which the Fed will withdraw monetary stimulus has greatly accelerated. Last December, the Fed had projected just three interest rate increases in 2022. However, with rising inflation, the Fed was forced to revise this number to seven rate increases this year. Moreover, the Fed may have to raise rates by a larger-than-normal 0.5% at their next meeting in May. In this May meeting, the Fed will also likely layout plans to start selling off the $9 trillion in Treasuries and mortgages they hold.

When the Fed talks about raising interest rates, they are referring to the short-term rates. While the Fed more or less directly controls short-term rates (such as the 1-month treasury rate), market supply and demand sets the long-term rates (5, 10, 30-year Treasuries). These long-term rates also soared during Q1 with the 10-year Treasury rate increasing by 1.0% from 1.4% in December to 2.4% currently. These long-term rates directly affect mortgage rates and is the key driver behind the rise in the 30-year mortgage rate to 4.6%. Most people intuitively understand that higher interest rates are a headwind to the housing market. However, higher interest rates also slow economic growth and lead to lower stock valuations as well.

“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”

Warren Buffett

Low interest rates have been repeatedly cited as one potential justification for the extremely high stock market valuations. As interest rates increase, this justification for high valuations becomes weaker and weaker.

Not only have interest rates increased recently, but a rare phenomenon called an inverted yield curve also just occurred. An inverted yield curve occurs when the rate on the 2-year Treasury is lower than the yield on the 10-year Treasury. This is an unnatural occurrence as investors normally demand a higher interest rate for lending over longer periods such as 10 years. What is most scary about an inverted yield curve is that it has been a fairly good predictor of coming recessions. As the chart below illustrates, every single recession (vertical grey bars) since 1980 has been preceded by a yield-curve inversion (blue line dropping below zero).

Note that this doesn’t mean a recession is imminent, but it does mean the risks of a recession occurring over the next year or so have increased significantly.

With high stock valuations, rising interest rates, and an inverted yield curve, the outlook for US stocks is rather poor for both the near-term and longer-term. This is an environment to be cautious, not risk seeking. Investors are advised to consult with their financial advisors on whether a more defensive stance is warranted for their portfolios.

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