Investment Outlook, September 2022
September 28, 2022
“Keep At It”
After an encouraging start to the summer, the markets have tumbled again, dropping almost 8% so far in September and pulling the S&P 500 down over 23% so far this year. The bond market index is down over 15%. The Fed’s continued message that it will “Keep at it,” raising rates until inflation is tamed, has set global markets and central banks into renewed turmoil. Britain’s recent plan to unleash meaningful fiscal support to consumers while simultaneously raising rates kicked off this month’s market plunge as investors have become increasingly concerned about the rest of the world’s resolve to fight inflation. We believe the recent volatility will be short lived. We often say that markets can digest good news and bad news, but they hate uncertainty. As we look forward, the news is likely “bad,” but we believe uncertainty is again receding and markets can begin to move forward.
For the first half of this year investors were trying to assess the magnitude of the damage from Russia’s invasion of Ukraine while still measuring the economic risks of COVID-related inflation. The pace of the U.S. policy response was unclear, and our economic outlook was anybody’s guess. With continued interest rate hikes leading to an eventual decline in the labor market, there is likely a recession in our future – if we are not already in it. While these are not positive trends for our economy, they provide more clarity today than they did in the past nine months and that clarity will allow investors to start looking past the recession to the future. When recessions are anticipated, they tend to be shorter, milder, and more predictable for businesses to manage and investors to navigate.
At the start of the year, COVID related inflation was beginning to recede naturally. Today’s more entrenched inflation is similar to the 70’s in that it is primarily the result of politically motivated actions that have disrupted the global energy supply— in this case Russia’s invasion of Ukraine.
Recently we have seen oil prices retreat meaningfully partially due to the release of the U.S. strategic petroleum reserve and reduced travel as consumers anticipate an economic slowdown. Time will tell if this bought us enough time to allow producers to ramp up production and European nations to find alternative sources of natural gas for their winter needs.
The most recent reading on overall inflation did not pull back as expected, but our focus will remain on energy prices. As energy prices retreat, the relief flows through to core items in CPI bringing overall inflation down over time. Going forward, we do not know how long it will take for inflation to recede to acceptable levels and we anticipate we may have slightly elevated inflation for some time.
Inflation is not always the enemy of our economy, though; it pushes savings rates up, makes fixed debt more manageable, and encourages wage and income gains. Portfolios can still grow successfully in an inflationary environment by focusing on sectors that have pricing flexibility or exposure to real assets that maintain their value.
Interest Rates and Our Fed
Interest rate policy is central to the decline in the bond market and the move away from growth stocks in the market so far this year. The Federal Funds target rate has gone from 0/0.25% a year ago to 3.00/3.25% just last week. 2-year U.S Treasury bonds now offer over 4% returns.
Chairman Powell is channeling lessons from Paul Volker and sharing a clear message that the Federal Reserve will “Keep at it,” raising rates and managing its balance sheet until inflation sustainably declines to a 2% target. These aggressive interest rate hikes just might overshoot, though.
Historically, monetary policy takes about 6 months to work through the economy, which is why interest rates policy is often changed slowly to assess the results along the way. With its current resolve, the Fed has stated that it will continue to raise rates steadily and tolerate the economic consequences of overshooting.
At this point, we expect the Fed to raise rates well over 4%. In fact, investors in the market have been anticipating this all year as price-to-earnings ratios have declined even as corporate earnings have grown this year. More recently, corporate earnings estimates for next year have declined further as well. In this way, we believe markets have already discounted higher rates to come and an economic recession.
While the Federal Reserve has been focused on the U.S., we exist in a global economy, and the string of rate increases this year has strengthened the U.S. Dollar creating turmoil in the rest of the world this summer. The strong dollar supports our consumers by mitigating higher prices a bit, but it increases the pain for countries that buy our goods and rely on our resources. It particularly hurts oil purchases for the rest of the world as oil is priced in dollars. It is also damaging to emerging economies who rely on dollar denominated debt. The U.S. dollar strength is a drag on our own multi-national corporations who produce and sell goods around the world and it threatens the health of our trading partners. Ultimately it is difficult for the U.S. to grow if the rest of the world is not growing.
Coming out of the 2008 financial crisis, the central banks of the world entered an unprecedented period of coordinated action. Today, we are even more of an intertwined global society, but there has been no coordination of policy. Our Fed is focused on U.S challenges alone and most other central banks are looking inward as well. Many countries have been forced to use their own balance sheet to support their local currency in the global market against the dollar’s strength. Strong countries may have the resources to keep doing this, but many countries do not have the reserves to keep supporting their currency, leading to even higher inflation for their own economies— and ultimately deeper recessions.
The war on inflation has created a doubly challenging year for investors as both bonds and stocks have unusually declined together. Portfolios that were positioned for increased safety this year, with larger bond allocations, have not enjoyed the capital protection that bonds usually provide. Holding individual bonds to maturity, though, assures us that values will recover fully with attractive returns from here. The Federal Reserve will raise rates two more times yet this year, and we will be looking for the opportunity to lock in 4-5% future yields in portfolios.
Stocks are currently re-testing the lows of early this summer, but with increased clarity from the Federal Reserve, we believe markets now reflect prices that have adjusted for the upcoming economy. We have used the summer to harvest losses for taxable clients and to focus portfolios on our highest-confidence sectors and positions for both a slowing economy as well as an eventual recovery. We know it has been a painful year, but we expect some market recovery yet later this year and believe that investors can begin to look into 2023 with increasing confidence in the trajectory of our economy.