Many economists believe the Federal Reserve reacted too slowly to runaway inflation. For months, Chairman Jerome Powell said rising prices were a temporary problem, even after inflation blew by the 2% target in March 2021. But prices continued to skyrocket throughout the year, and the Fed eventually acknowledged its mistake. When the central bank finally got around to raising interest rates in March 2022, inflation had reached a four-decade high. Since then, officials have compensated by implementing the most aggressive series of rate hikes since the early 1980s.
Many economists now believe the Fed is tightening too quickly. Indeed, officials approved a quarter-point rate hike last month -- the ninth consecutive rate increase -- even as bank failures rattled Wall Street. And Fed policymakers expect one more quarter-point hike in 2023. That decision adds another layer of complexity to an already-challenging situation. Banking turmoil could further tighten lending conditions, amplifying the already-fierce headwinds to economic growth, and that could ultimately lead to a recession.
In fact, JPMorgan Chase analysts estimate the odds of a U.S. recession at greater than 50% before the end of the year. Here's what investors should know.
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The stock market is forward-looking
The S&P 500 slipped into a bear market in January 2022. The index started falling before the Fed began raising interest rates because investors expected the rate hikes to happen. More accurately, investors expected the higher cost of borrowing to hinder economic growth by suppressing business investments and consumer spending. That has indeed happened. Gross domestic product (GDP) declined in the first and second quarters of 2022, and the economy is expected to grow at a muted pace through 2024. That implies weak growth (or even declines) in corporate profits, so stock prices dropped sharply.
But the forward-looking nature of the market works both ways. The S&P 500 bottomed before the GDP bottomed in every recession during the past 50 years, excluding the one that followed the dot-com crash. That means investors who waited for proof that the economy was improving missed part of the stock market's rebound, and missing just a few good days can do lasting damage to a portfolio. For that reason, investors should not let recession fears keep them out of the stock market. The S&P 500 has already fallen sharply and, while it may fall further, the index will likely start rising toward new highs before economic activity improves.
Stay invested (and keep investing) through the bear market
In the last two decades, about 42% of the S&P 500 index's best days occurred during bear markets, and another 34% occurred during the first two months of a new bull market (i.e., before it was clear the bear market had ended), according to Hartford Funds. Investors that missed even a few of those days suffered devastating consequences.
Case in point: $10,000 invested in the S&P 500 at the end of 2007 would have grown into $35,461 by the end of 2022, representing an annual return of 8.8%. But removing the 10 best days from the equation reduces the annual return to 3.3%, meaning the initial investment of $10,000 would have grown into just $16,246. That means investors who sat on the sidelines during bear markets -- such as the one that occurred during the Great Recession -- paid a high price for attempting to time the market.
Here's the bottom line: Yes, some financial experts are forecasting a recession, but that doesn't mean investors should sell stocks or avoid the stock market. It makes more sense to stay invested and to keep investing during the drawdown. Doing anything else will likely lead to lower returns in the long run.
