by Jordan Hucht, CFP®, ChFC®, AIF®

Coming into the year, 2022 market narrative, and I posited that the focus would shift from inflation and rate hikes to recession and earnings. And now here we are, 3 months and a few bank failures later, starting to feel the real effects of the fastest rise in interest rates in decades. It feels like we’re walking on eggshells as we wait to see whether the economy will crack under the pressure.

Though the first quarter was a strong one for investors (notably, exactly the opposite of what most “experts” predicted), with stocks and bonds both posting positive returns, I’d argue that recession risks have risen. Let’s explore why.

First, let’s back up and recount what’s happened over the past year. Last spring, the Fed set off on a rate-hiking cycle to battle inflation, which had proved far more persistent than the Fed predicted. From March 2022 to March 2023, the Fed increased the federal funds rate by 4.75 percentage points, the fastest such move since the 1980s. The immediate market reaction was a sharp decline in stock prices (higher interest rates = lower stock valuations) as well as a decline in the value of bonds (bond prices decline as interest rates rise).

The selloff in stocks was fairly sharp in the beginning – the S&P 500 lost more than 20% of its value in the first half of 2022 – but we’ve essentially traded sideways since then and are currently sitting around early 2021 levels. As I’ve written before, this bear market has been meaningful but still very much within the bounds of market declines we’ve seen many times in the past. In other words, it’s about average – so far.

Though we’ve seen the market reaction to the Fed’s policy tightening measures, what we haven’t really seen yet is the impact on the actual economy, and subsequently, on corporate earnings. We started to get a taste of this in recent weeks, as we saw several bank failures (more on that below), but by and large, the economy – especially the consumer – has held up. And as an extension of that, so have corporate earnings. That’s why we’ve had some ups and downs along the way, but we’ve basically gone nowhere since last summer. Two steps forward, two steps back.

We’re doing the two-step on a dancefloor of eggshells, where it’s going to be tough for the song to end without at least a few cracks.

And that brings us to the stress we’ve seen in the regional banking system over the past few weeks, most notably, the collapse of Silicon Valley Bank. Without going into painstaking detail, essentially the sharp rise in interest rates led to a decline in the value of the assets the bank held, which led to concerns about liquidity, which led a rush to withdraw deposits, which made the liquidity concerns a self-fulfilling prophecy and the bank was quickly in the hands of the FDIC. The fear of contagion was relatively muted (or at least it has been so far) as there was quick response from the public and private sectors, and the broader market essentially shrugged it off.

Even though the banking turmoil hasn’t turned into a full-on banking crisis, it will almost surely lead to a slowdown in lending, and such a credit contraction will also slow economic growth. Remember that the intent of the Fed’s policy moves is to tighten monetary conditions by making credit more expensive and harder to come by, so on that front, it’s somewhat mission accomplished (albeit in a painful way). Slowing growth enough to tame inflation is the goal, but the risk is going too far and pushing the economy into recession. The events of the past few weeks have elevated this risk.

So what happens next, and most importantly, what do we do?

As I’ve suggested before, it’s my belief that the stock market’s decline so far has been mostly the product of lower valuations due to higher interest rates and the expectation of a mild amount of earnings declines. Though there will likely be a lot of noise and volatility in the near term, what will matter in the longer term is the extent of the impact to earnings from tightening credit conditions. If it’s mild, the market is probably prepared; if it’s more severe, probably not. We’ll get a window into that over the next few weeks as we enter the first quarter’s earnings season, but realistically, it’ll take months before we have some real clarity.

In better news, and in stark contrast to last year, bonds are providing investors the highest yields in years and relative stability of principal – exactly what they’re intended to do in a diversified portfolio. There’s also the potential for tailwinds to bond prices if rates decline (which they did during the first quarter) as the economy slows, setting the stage for a potentially robust year for bondholders. Meanwhile, the third primary asset class – cash – is becoming an increasingly productive component to overall return.

From a financial planning and asset allocation perspective, there’s a lot that can be done to prevent the current macro risks from derailing your financial future. Careful planning and a thoughtful allocation across asset classes – stocks, bonds, cash, and alternatives – can provide a path to long-term success. I’ll leave you with this:

Patience and discipline are what unlock the value of stocks over the long run; financial planning and asset allocation are what allow for patience and discipline.

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Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.