A U-shaped rebound ahead?

This past week markets continued to face downward pressure, with Wednesday marking the biggest one-day decline in the S&P 500 since June 2020. Equity markets broadly are now down for the seventh week in a row, and the S&P 500 approached a technical bear market – or 20% pullback – but closed the week down about 18% year-to-date1.

However, in our view, a recession is not a base-case scenario over the next 12 months, and markets may experience a gradual "U-shaped" recovery in the months ahead.

What's causing the market weakness? Fears of a recession and profit-margin pressures intensify

Markets were especially rattled last week by earnings reports from key retail giants like Walmart and Target. Both companies reported lower-than-expected operating margins, driven by higher input costs from areas like freight and fuel.

However, the retail giants stated that consumer traffic remained robust, underscoring a resilient U.S. consumer. For example, Target saw a solid 4% yearly increase in its store traffic in the first quarter1. There was some shift in what consumers were purchasing, moving away from pandemic staples, and, in some cases, lower-end consumers did look for bargain brands or shopped less than average. But overall, the disappointment seemed to come more from the supply side than demand.

Markets nonetheless seemed to interpret these earnings as a signal that the worst was yet to come, fearing that peak consumer demand and peak margins may be behind us. However, Target's CEO highlighted that he continued to see strong foot traffic in May, and that he expects some supply-chain and inventory issues to ease in the back half of the year.

Recession is still not the base-case scenario

As the earnings misses demonstrate, risks to growth are certainly rising in this backdrop. Elevated inflationary pressures, ongoing supply-chain issues, and a Federal Reserve that seems determined to raise rates aggressively for now have all driven market fears of a recession. In fact, with the S&P now down close to 18%, equity markets have priced in about a 75% chance of a recession1.

However, in our view, recession is not a base-case scenario over the next 12 months. We continue to see solid economic fundamentals, including a healthy consumer, a tight labor market with low unemployment, rising wages, and corporate earnings growth that, while moderating, will likely remain in the mid-single digits. This past week we also saw retail sales figures that exceeded expectations for the month of April, and industrial production that also expanded at a monthly rate of 1.1%, above forecasts of 0.4%1.

If we are experiencing a nonrecessionary market correction today, history has offered a favorable outlook for these periods. Since 1970, the return is, on average, 17% in the six months after the market bottoms1. Calling market bottoms (or tops) is notoriously difficult, but with equity market valuations having come down nearly 25% and a sizeable amount of recession fear priced in, the risk versus reward certainly looks more favorable here (and perhaps skewed towards an upside surprise).

Could markets rebound from here? We think a U-shaped recovery is plausible

If this current downturn is a correction, and not a recession-driven bear market, investors may be wondering if they should be "buying the dip". In recent history, the "buy the dip" mentality has worked well, as markets have quickly recovered losses after big pullbacks. However, if we do see a market recovery in the months ahead, we believe it will likely take time to recover the losses we have seen – what we are calling a U-shaped rebound, versus the more recent V-shaped recoveries.

If you consider the last two major market downturns – the 2018 growth scare and 2020 pandemic downturn – both had a couple of things in common. First, markets recovered their losses in these periods relatively quickly, around three months on average. Second, what drove the recovery was that the Federal Reserve stepped in and signaled lower interest rates ahead.

 The chart displays the last two corrections which recovered quickly in a 'V' shape.

Source: FactSet

The chart displays the last two corrections which recovered quickly in a 'V' shape.

Past performance is not a guarantee of future results. The S&P 500 is an unmanaged account and cannot be invested in directly.


The key difference in the current pullback is, of course, that the Federal Reserve is on a mission right now to raise rates and fight inflation. Fed Chair Jerome Powell has indicated that the Fed will continue to raise rates steadily until it sees "clear and convincing" evidence that inflation is moving lower.

In our view, inflation will likely moderate in the months ahead, but it will come down gradually. We see headline inflation heading towards 5% - 6% this year, driven by both tougher yearly comparisons and better supply-and-demand dynamics. If the Fed does see a trend of lower inflation, perhaps confirmed by three or four lower readings, we could see a shift in its rhetoric and pace of rate hikes.

Chart 1. Our base-case scenario calls for headline inflation to moderate to the 5% - 6% range this year

Base-case Scenario
 Bull CaseBase CaseBear Case
Headline Inflation (CPI, year-over-year %)4% - 5%5% - 6%6% - 7%
Fed policyFed is able to pause tightening cycle by year-endFed is able to move at a more gradual pace by year-endFed must continue to move aggressively all year
Economic growth2.5% - 3.5%1.5% - 2.5Sub 2.0% (recession likely)
    

Source: Edward Jones

This table provides possible scenario's for inflation and economic growth.


If the Fed signals it will raise rates at a more gradual pace, or perhaps even skip a meeting, this could spark a more sustained market recovery. But keep in mind the recovery process could be more gradual than we have seen in the past.

How balanced portfolios can add value

The other part of this downturn that has been especially challenging for a diversified investor is that both equity and bond markets have sold off together, both down generally over 10% for the year. However, despite headlines questioning the viability of the 60-40 portfolio, we continue to see value in such a diversified, balanced strategy.

Generally, in periods of extreme market downturns, balanced portfolios can help avoid the full downside from a big market pullback, while they perform more conservatively in up markets. This has helped investors seeking less risk and who have more of a focus on the preservation of capital.

How balanced portfolios can add value
 

Bear Market

(Tech Crash '00-'02)

Bear Market

(Financial Crisis '07-'09)

Bear Market

(COVID-19 '20)

2022

(Year-to-date)

Entire Return Period

('00-'22)

Stock Market-46%-55%-34%-17%316%
Balanced Portfolio-14%-33%-17%-13%245%
      

Source: Morningstar Direct. Stock market measured by the total return of the S&P 500 Index. Balanced portfolio measured by Edward Jones Balanced Growth and Income portfolio. Past performance is not a guarantee of future returns. Indexes are unmanaged and cannot be invested in directly.

This table shows that a balanced portfolio has held up well since 2000 through the market corrections.


The good news is that history is on our side here, as well. In periods when balanced portfolios have been down over 5% in a quarter, over the next four quarters we tend to see about a 12% return on average1.

 This chart shows that returns following a negative 5% quarter are normally strong.

Source: Source: Morningstar Direct, Edward Jones Calculations. Balanced portfolio represented by 60% S&P 500 and 40% Bloomberg US Aggregate Return rebalanced monthly. Past performance is not a guarantee of future returns. Indexes are unmanaged and cannot be invested in directly.

This chart shows that returns following a negative 5% quarter are normally strong.


Volatility is a normal part of a business cycle and could offer opportunities

While this year has been a challenging one for many investors across asset classes, history has shown that it is better to have time in the market rather than trying to time yourself in and out of the market. Over time, innovation and productivity gains tend to drive economic growth and send market returns upwards. And while market volatility may not feel comfortable, it is generally a normal part of any business cycle. These periods are often an opportune time to have a discussion with a trusted advisor to

  • Ensure your portfolio is appropriately diversified;
  • Rebalance assets if necessary – particularly after large market swings; and
  • Look to add quality investments at more favorable prices and valuations over time, in both equities and bonds.

Ultimately, while we may not see a swift "V-shaped" recovery this cycle, a more gradual "U-shaped" recovery process could be underway.

Mona Mahajan,
Investment Strategist

Source: 1. Bloomberg


Weekly market stats

Weekly market stats
INDEXCLOSEWEEKYTD
Dow Jones Industrial Average31,262-2.9%-14.0%
S&P 500 Index3,901-3.0%-18.1%
NASDAQ11,355-3.8%-27.4%
MSCI EAFE1,9731.6%-15.6%
10-yr Treasury Yield2.79%-0.1%1.2%
Oil ($/bbl)$110.820.3%47.3%
Bonds$103.160.6%-9.3%

Source: Factset. 05/13/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 05/16/2022.

The week ahead

Important economic data being released this week include the PMI composite and consumer expenditures.

Review last week's weekly market update.


Mona Mahajan

Mona Mahajan is responsible for developing and communicating the firm's macroeconomic and financial market views. Her background includes equity and fixed income analysis, global investment strategy and portfolio management.

She regularly appears on CNBC and Bloomberg TV, and in The Wall Street Journal and Barron’s.

Mona has a master’s in business administration from Harvard Business School and bachelor's degrees in finance and computer science from the Wharton School and the School of Engineering at the University of Pennsylvania.

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Important Information:

The Weekly Market Update is published every Friday, after market close. 

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