Market Update Letter – The One-Two Punch

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Markets volatility

The One-Two Punch

Dear Clients and Friends,

The bull market of 2019 to 2021 is starting to feel like a distant memory. Markets in 2022 are off to a rocky start, with stocks entering a double-dip correction (down at least 10%) amid dual pressures from the Federal Reserve and Russia’s attack on neighboring Ukraine. Stocks are taking a beating as investors brace for a potential lethal combination: an upper cut from rising interest rates and a body blow from Russian aggression that stands to threaten global growth and commodity supply chains already struggling to recover from COVID.

This client letter will try to frame the current market volatility and outline scenarios for where markets may be headed. Our current bottom line: We see more upside than downside from current levels, and we are inclined to maintain current allocations of both equities and bonds.

Russia hits hard

The gradual Russian military buildup and today’s large-scale attack on Ukraine have given investors plenty of time to consider worst-case scenarios such as loss of life, regional instability, a sharp drop in Russian oil and gas exports, and potentially a spike in global inflation. These high-risk scenarios are driving investors away from risky assets (stocks and high yield bonds) and toward safe-haven securities (U.S. Treasuries).

Since Russia’s initial threat to the Ukraine on February 8, broad U.S. markets have declined 8% (through yesterday’s close). How does this compare to other geopolitical events throughout history that have impacted stocks? While there is a bit of art and science here, historically we’ve seen a pattern where geopolitical conflicts and unexpected market shocks usually depress stock prices by about ~4%.

If historical patterns hold and if the Ukraine situation has already taken markets down by 5% or more, then U.S. markets seem poised to recover. Despite this potentially favorable scenario, investors are now struggling with fears of more downside if Russia expands its aggression. What’s more, history suggests that markets take nearly 40 days to return to pre-crisis levels.

The Fed tightens its grip

What else could possibly derail markets even more in the next 40 days? Right on cue, the Federal Reserve has a meeting scheduled for March 16, when Jerome Powell is expected to announce the first of many increases in short-term interest rates, which is intended to slow an overheating economy and curb inflation. The Fed plans to tighten monetary policy as unemployment remains low and inflation signals remain elevated.

Investors are now wrestling with the speed of Fed tightening. Stocks may decline amid more interest rate hikes and a rapid reversal of the Fed’s money printing strategy post-COVID (also known as “shrinking” the Fed’s balance sheet). At the moment, investors see about a 65% chance that the Fed raises rates only by a quarter of a point next month. But just a week ago (before Russia entered Eastern Ukraine), investors were wondering if a half-point rate hike was looming. With new risk factors, as well as declining markets, investors are essentially betting that the Fed will keep the kid gloves on while taking actions to slow the economy.

A knock-out or a recovery?

With the twin pressures of the Fed and geopolitics driving a year to date 12% decline in broad markets as of yesterday, investors are looking for signals of what’s next. One way to frame this year’s market decline is to look at historical patterns of intra-year, peak-to-trough drawdowns: Historically, markets decline about 14% each calendar year.

While every cycle is somewhat different, this historical framework suggests that we could be inching closer to a near-term bottom. If this pattern holds, we would expect a gradual recovery over the next few weeks.

To that end, we continue to receive client inquiries around timing of adding capital to portfolios. While we are not believers in market timing, opportunistically deploying long-term liquid capital into higher returning compounding assets is an effective investing strategy. Therefore, if you have current liquidity that you can invest for a longer time horizon, this may be a good opportunity to start moving those funds into your diversified portfolio. Just as the market correction should be pulling those funds off the sidelines, low interest rates on cash and high inflation should be pushing investors to consider this as well.

We will continue to follow the unfolding events in both Ukraine and at the Federal Reserve as we evaluate the investment approaches that fit these dynamic risk-return scenarios. As always, we will keep an eye on both short-term and long-term investment opportunities that meet our core investment principles and your individual goals. Please reach out to us if you have any questions about current market conditions or your specific portfolio. We appreciate your continued trust and confidence in the FBB team.

With warm wishes for Spring,

Michael Bailey, CFA
Director of Research

Michael Mussio, CFA, CFP®
President

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