Market Volatility: Inflation Fears Strike Again

Inflation concerns on Friday once again pulled the rug from under investors struggling to find their footing as the Federal Reserve’s battle against rising consumer prices shakes the economic terrain. The broad S&P 500® Index fell 2.4%, while the tech-focused Nasdaq dropped 3.1%

Stocks gave up on a short but sharp rally after preliminary survey data from the University of Michigan showed consumers’ expectations for the path of prices worsened between September and October. The survey’s median expectation for the inflation rate in October 2023 rose to 5.1%, from a year-ahead rate of 4.7% in September. At the same time, respondents’ expectations of inflation five years from now also grew more pessimistic. Those findings came a day after government data showed the annual inflation rate remained high in September.

Negative views about inflation can become a self-fulfilling prophecy if consumers start buying more today in anticipation of higher prices tomorrow—which raises the follow-on risk that the Fed will maintain its aggressive posture toward interest rates.

The central bank has already raised its benchmark lending rate by three full percentage points so far this year. It is now expected to hit 4.5% by the end of the year. Rate increases take time to work their way through the economy, so the speed at which rates have risen raises the risk the Fed might go too far. At the same time, any sign the Fed might be backing off should be treated with caution—a sudden reversal would probably not be a vote of confidence in the economy’s health.

Notwithstanding the continued rise in consumer prices, the economy shrank during the first six months this year and forward-looking measures of activity suggest the situation hasn’t improved. Some investors have hoped such weakness might persuade the Fed to ease up on its campaign against rising consumer prices, leading to periodic and temporary rallies in stock prices. However, Fed officials have repeatedly quashed these hopes with aggressive commentary on inflation and the future path of rates. The concern now is that the steep rise in borrowing costs this year will push an already weakening economy into recession.

What does that mean for investors? Quality is the order of the day when it comes to both stocks and bonds. For stocks, Schwab recommends taking a sector-neutral approach and focusing on factors such as strong profit margins, high free-cash-flow yield, low volatility, and positive forward earnings revisions. For bonds, that means focusing on Treasuries, certificates of deposit (CDs), and investment-grade municipal and corporate bonds.

In the face of rapidly shifting markets, investors should also consider periodically rebalancing their portfolios to maintain their strategic long-term allocations.

U.S. stocks: Volatility likely to persist

  • The S&P 500 posted significant gains Thursday, despite a hotter-than-expected inflation report for September, opening the day 2.4% lower only to close 2.6% higher. Friday’s drop didn’t erase that entire gain, but the wild two-day swing reinforced how volatile the market is now—making it much like previous bear markets.
  • As Fed officials have made clear in the past, financial market volatility in and of itself won’t affect their rate decisions. While financial system instability could prompt an intervention, that would hardly be positive for risk assets.

Bonds: Conditions tightening

  • The yield curve should continue to invert. Short-term rates may keep rising as the Fed hikes rates, while the upside for long-term yields is limited.
  • The odds are growing the Fed could enact three-quarter-point interest rate increases in both November and December. The fed fund futures market is now pricing in a peak federal funds rate of nearly 5% by next spring.
  • The 10-year Treasury yield tends to top out near the peak federal funds rate of a given cycle. With the markets now pricing in a peak federal funds rate near 5%, the 10-year Treasury yield could drift slightly higher, but the prospect of rate cuts down the road should limit the upside.
  • We suggest investors modestly extend the duration of their bond holdings now rather than waiting for the Fed to finish hiking rates.

Global stocks: Earnings Watch

  • International stocks fell less than U.S. stocks but were still lower. In the United Kingdom, Prime Minister Liz Truss scrapped a plan to cut corporate taxes, but that wasn’t enough to placate markets. The pound and government bonds both fell, though not by enough to set new records for the year.
  • Investors will be paying close attention to commentary from corporate management teams as earnings season kicks off. Goods-related companies are having to adjust after the pandemic pulled forward demand for certain items, while inflation and higher borrowing costs are likely to impact future earnings.
  • Dividends can help protect portfolios from volatility. Stocks that pay high dividends have been outperforming across countries and sectors this year. We believe they could continue to do so over the intermediate term.

Trading takeaways: Bearish Signals

  • Major indexes appear to be at a critical juncture technically. All major indexes put in the largest bullish engulfing candle of the year on Thursday, which could suggest a near-term trading bottom. Technicals for the Nasdaq have a bearish tilt: It is below its 200-week simple moving average for the first time since the 2008-2009 financial crisis. Meanwhile, both the S&P 500 and the Dow Jones Industrial Average closed just below their respective 200-week SMAs.
  • Volatility remains elevated. The Cboe Volatility Index (VIX) backed off the upper end of its 20-35 year-to-date trading range once again, closing up 0.25% at 32.20, but the uptrend that started in mid-August remains intact. Additionally, the VIX futures term structure remains relatively flat looking out six months, which suggests uncertainty about the current trading environment. At its current level, the VIX is implying daily moves in the S&P 500 of about 60 points (1.67%) in either (or both) directions.
  • Equity traders who are uncomfortable with volatility should consider reducing trade size or waiting on the sidelines. Since the current market volatility may not abate any time soon, traders may want to consider whether this is an environment in which they want to be trading. Sometimes the best trade is no trade at all.

What should long-term investors do now?

Market volatility is unsettling, but historically not unusual. If you’ve built an appropriately diversified portfolio that matches your time horizon and risk tolerance, it’s likely the recent market drop will be a mere blip in your long-term investing plan.

However, it can be hard to do nothing when markets are rough. Here are some things to consider:

  • Harvest some investment losses to lower your tax liability. Selling for a loss is never easy, but you can use those losses to offset gains you may have realized in your taxable accounts over the course of the year—a strategy known as tax-loss harvesting—and then reinvest in holdings similar, but not identical to, the ones you sold. (Just beware of wash sales.) If you don't have investment gains to offset, or if you realize more losses than gains, you can use up to $3,000 in losses to reduce your ordinary income this year—and every year thereafter—until the entire loss is accounted for.
  • If your plan calls for it, continue making regular investments. Finding the perfect time to invest is nearly impossible. Time in the market is what matters. While staying the course and continuing to invest even when markets dip may be hard on your nerves, it can be healthier for your portfolio and can result in greater accumulated wealth over time.
  • Retirees should maintain a reserve. No matter the market conditions, we recommend holding the equivalent of a least a year's worth of anticipated withdrawals in cash investments—such as checking or savings accounts, money market funds, or certificates of deposit (CDs)—with another two to four years’ worth in relatively liquid, conservative investments such as short-term Treasuries and other high-quality bonds or short-term bond funds. If you don’t have that kind of reserve, you may need to consider other options.

Read more about Schwab’s perspective on current markets.

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