The summer has come and is nearly gone. While markets enjoyed a sense of calm for most of the season, the same cannot be said of the past few weeks. Volatility has resurfaced, and along with it, weakness in global equity and fixed income markets. We share some brief thoughts below.
The catalyst for the recent softness was a speech delivered by U.S. Federal Reserve Chairman Jerome Powell. In it, he indicated that the U.S. Federal Reserve, the country’s central bank, is drawing on lessons learned in the past as it tries to deal with the current inflationary period. More specifically, he outlined three lessons learned from the high and volatile inflation period experienced during the 1970s and 1980s, and the low and stable inflation witnessed thereafter.
The first is that while monetary policy can only address demand, as opposed to supply, it is still a key responsibility of theirs and the Fed remains committed to moderating demand to better align it with supply. The second lesson is that inflation can be self-fulfilling. More specifically, when expectations of high inflation become entrenched in the decisions of households and businesses, it has a tendency to fuel even higher inflation. As a result, it is important to ensure longer-term inflation expectations remain well-anchored, which fortunately is the case presently. Its last lesson, which we took away as its most forceful message, was that central banks must maintain a restrictive policy until inflation returns convincingly to a low and stable state. Mr. Powell acknowledged its approach could result in some “pain” for households and businesses, but viewed the risk of long lasting price pressures as being even more painful.
Throughout the summer, markets had started to price in a growing expectation that central banks would potentially reverse course next year with their monetary policy and begin to lower interest rates in response to economic weakness. While that may still be possible, it seems increasingly unlikely in the wake of Mr. Powell’s speech. Predictably, markets have sold off in response to the appreciation that tighter financial conditions are here to stay for some time to come.
The Federal Reserve, and other central banks like the Bank of Canada, seem very willing to tolerate a period of economic weakness in order to bring inflation under control. Investors too will have to be tolerant, patient, and prepared for a period where interest rates are higher for longer. Moreover, investors should prepare for weaker growth as demand from businesses and consumers wanes in the face of higher borrowing costs. That does not mean we, as investors, should just stand pat. To the contrary, bouts of turbulence and broad market weakness often create opportunities to rebalance and / or reallocate fixed income towards equities, or vice-versa. We will continue to take actions of this nature in the future, just as we’ve done in prior episodes of market volatility.
Market Decline and Recovery Results
The peak-to-trough numbers for the COVID-19 market decline and subsequent recovery are provided in the table below, as of today’s closing prices.
