Tuesday’s CPI report for the month of August came hotter than expected—and likely cements the Fed’s decision to hike rates 0.75% at their meeting next week. While declining gasoline prices helped keep a lid on headline inflation—which increased 0.1% versus an expected decline of 0.1%–the core measure that excludes food and energy prices (core inflation) increased a staggering 0.6% for the month and suggests that inflation is broadening out across the economy. Equity markets declined significantly on the news on Tuesday, with the S&P 500 Index and growth-heavy NASDAQ falling 4.3% and 5.2%, respectively—the market’s worst trading day since June 2020. Interest rates rose, with the 2-year treasury rising 0.17%.
By any measure, this is not what economists or markets were expecting. Jerome Powell’s hawkish comments from Jackson Hole in late August similarly caught the market off guard—how, we thought, could he be so committed to hiking rates when evidence suggests inflation is moderating? Big declines in gasoline prices, easing supply chains, and steeply higher interest rates on all sorts of consumer borrowing were widely (and rightly) expected to help bring down consumer prices. Only that didn’t happen—at least not yet—and the Fed is now all but certain to continue hiking rates higher and for longer in the months ahead. It appears Mr. Powell, after all, may know something the market doesn’t.
What are investors to make of all this? In our view, today’s news presents three powerfully important reminders for investors.
The first is that, with billions of participants and a complex web of global supply chains, the global economy is infinitely complex. Attempting to draw simple, cause-and-effect relationships—no matter how well-reasoned our expectations—is exceptionally difficult. Even PhDs in economics struggle to define the future. Whether we’re talking about inflation and interest rates or European stocks and the war in Europe, there is real wisdom in humility. The economy and markets can quickly—and painfully—prove us wrong.
The second is that humility is best manifested through broad diversification. As investors, we diversify portfolios not because of what we expect—after all, if our expectations were always right there would be no need to diversify—but to help protect against what we don’t. Successful investing isn’t about hitting home runs; it’s about avoiding strike outs. And the best way to put this lesson to work in portfolios is through broad asset class diversification. Is it perfect? No. Nothing is in life. But we believe diversification, often characterized as the only “free lunch” in markets, is the best approach to weathering difficult markets and to help successfully build long-term wealth.
Finally, we should remind ourselves that time in the market is more important than timing the market. Putting our faith in capitalism and long-term investing is far better than placing our faith in anyone promising god-like clairvoyance. Even now, with markets facing difficult headwinds and U.S. stocks down nearly 14% for the year, history strongly suggests investors should expect higher returns in the future. In fact, the record shows that after a 10% market decline, subsequent 1-, 3-, and 5-year returns have been exceptionally strong (see below exhibit). Moving out of markets when times get tough—selling low—only to re-enter markets when times are better—buying high—is not a recipe for success. Instead, a sound approach is to allow markets to work for you by remaining fully invested in a diversified portfolio—one that appropriately reflects your personal need, appetite, and capacity for risk.
Source: Fama/French Total US Market Research Index Returns, July 1926 – December 2021
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