Two possible paths forward for the economy and markets
This is usually how it works. Just when the world appears to be full of nothing but darkness and despair, the wind shifts and attitudes improve. The same often occurs in the opposite direction when conditions seem nearly perfect. Behavioral finance academics attribute this phenomenon to a distinctly human trait called recency bias. When current conditions feel extreme, they’re viewed as unprecedented and intractable even though history is replete with previous examples that were only temporary.
As of the date this commentary was written, the stock market has climbed more than 15% from its June 16 low. The rally followed a plunge that took some of the major indexes well into bear market territory earlier in the year. When the selloff began, investors were expecting rampant inflation and shortages attributable to Russia’s invasion of Ukraine. Spikes in interest rates, empty store shelves, $10 a gallon gasoline, and a stiff recession were just around the corner. Those expectations proved directionally correct, but extremes never materialized.
The post-pandemic story is still being written, but at this point, oil and other commodity prices, interest rates and inflation are either falling or rising at a slowing pace. They’re still higher than where they started the year, but they’re mostly well below levels that were previously expected. Changes in bond prices and spreads also indicate absence of extremes. Financial markets love all of this, so off to the races they go.
Consistent with history’s nearly unbroken track record, actual conditions differed from previous expectations, this time by a wide margin. Can we please put to rest the idea that future economic and financial market performance can be predicted? Sadly, the lessons of the post-pandemic era will likely be forgotten, and recency bias will live on. Many investors will view the next period of distress or euphoria as unique in history, and that will create false clarity about what will happen next. Add political bias to the mix (definitions of “recession” and analysis of inflation rates have become political Rorschach tests), and overconfidence about the ability to see the future will abound.
The best investors avoid this trap. They are humble and shun overconfidence when setting expectations about the future. They test their outlook to identify political bias that might cloud their thinking. They never place big bets that depend on an accurate forecast. They stay diversified, even when some asset classes produce negative returns. They are also contrarians who know consensus expectations are usually wrong. And they certainly don’t base their investment decisions on commentary from prognosticators who claim unique insight into the future.
We’ll dodge the mistakes we ask investors to avoid as we look forward from here. Specifically, rather than guess what will happen, we’ll discuss what could happen based on probabilities. We see two possible paths forward for the economy and markets:
First path: Rallying financial markets defy skeptics by being right about the rapidly rebalancing economy. This wouldn’t be the first time a stock market bounce is called a “bear market rally” until enough time passes to make it clear that it’s the first leg of a new bull run.
Second path: Financial markets underestimate the durability of the overheated economy and tightening financial conditions. Inflation rates continue to run hot, interest rates climb further, and a hard landing in the economy drives corporate profits and markets lower.
Most economists believe financial markets are currently oblivious to the greater likelihood of the second path, and they could be right. For the record, we believe the probability of the second path is higher than the first, making the sustainability of recent gains an iffy proposition. But the grain of salt good investors always use when evaluating opinions like ours should be sprinkled on our comments.
Scott D. Knapp, CFA, is chief market strategist with CUESolutions provider Cuna Mutual Group. He is responsible for investment philosophy development and program implementation for Cuna Mutual Group’s institutional retirement programs. He regularly speaks at economic and investment forums across the country.