A sustainable market rally will depend on the path of inflation
Overall, we believe that with the S&P 500 down close to 20%, markets are already discounting a fair amount of pessimism around the economy. We don't, however, see markets mounting a sustainable rally until we see evidence of moderating inflation – perhaps two to three consistently lower readings. In our view, this could happen by year-end, driven in part by a cooling housing market and potentially softer labor market. While headline inflation (driven by food and energy prices) is more volatile – and less impacted by rate hikes – we believe the Fed's aggressive policy decisions will support a gradual move lower in core inflation and bring down consumer demand over time.
If inflation does moderate, this could allow the Fed to move at a more gradual pace of tightening, which will support market sentiment broadly. This process may take time, perhaps through the second half of the year, and we may continue to see market volatility in the interim. We see this potential recovery as more "U-shaped versus the speedier "V-shaped" market rebounds we have seen in recent history. However, with markets having priced in a mild downturn already, we believe the upside versus downside in markets is certainly more compelling today.
Look to remain diversified and defensively positioned for now
For long-term investors, while market sell-offs are never comfortable, they have historically provided opportunities to diversify, rebalance and ultimately add quality investments to portfolios at better prices. Historically, the time to recovery from a bear-market sell-off has been on average 23 months, but for periods of shallower economic downturns – which we believe will be the case for this cycle – this recovery time is shortened to an average of 10 months (see chart below).
And if this is in fact a nonrecessionary market correction, history is also on our side: Since 1970, the return is, on average, 17% in the six months after the market bottoms. Calling market bottoms (or tops) is notoriously difficult, but with equity-market valuations having come down nearly 25% and with a sizable amount of recession fear priced in, we are likely closer to a bottoming process today.
In this backdrop, we would continue to remain more defensively positioned for now until we see a consistent moderation in inflation. Within equities, we would favor quality large-cap positions over small-cap, with a tilt towards value sectors of the market. And within fixed income, we would favor investment-grade bonds, which now offer better income opportunities and align investors with high-quality issuers. While volatility may remain elevated this year, the silver lining for investors could be that a gradual U-shaped recovery may be underway.
Figure 2. Average bear-market downturns and recovery times
