The third quarter began with a summer relief rally until Federal Reserve (“Fed”) Chairman Jerome Powell made it very clear to investors, “we’re not backing down”. Meaning that the Fed will battle inflation by aggressively raising interest rates even at the expense of economic growth. As investors finally got the message, the financial markets resumed their decline. By the end of the third quarter, U.S. stocks were trending towards their worst year since the 2008 financial crisis.
The Fed walks a tightrope. While it has to take steps to “cool down” the economy and bring inflation under control, it aims to do so without causing a severe recession. A strong economy generally leads to more jobs but quickly rising prices, while a sluggish economy can lead to fewer jobs but slower price increases. The Fed constantly is aiming to balance those two extremes with limited, but powerful tools.
Why does the Fed care about high inflation? When businesses and consumers begin to expect high levels of inflation, when it becomes entrenched in everyone’s considerations of the future, the world gets wacky. People stock up on products because “they can only” get more expensive later. Businesses start making pre-mature investment decisions. Workers, expecting their salaries to buy less each year, demand wage increases. Currencies deteriorate in value. Wealth, overall, erodes. High inflation is bad for business. Anyone who lived through the 1970’s and early 1980’s remembers just how bad it can be for the average consumer as well.
How can the Fed affect inflation levels? The answer is interest rates. Interest rates, the cost to borrow money, drives so much of the economy. Historically, low interest rates stimulate growth because houses, cars, equipment all cost less to finance. To stimulate, or reign in, the economy, the Fed sets an important short term interest rate. During the COVID pandemic, the Fed dropped interest rates to nearly 0% to stimulate borrowing, but many would argue it overshot it. That’s when “bubble behavior” tends to start, such as investors gambling on cryptocurrencies and meme stocks. The euphoria and speculation seen in the financial markets last year were reminiscent of the tech bubble markets 20 years ago.
The Fed’s current playbook largely is shaped by the lessons learned from the last time the Fed faced serious inflation in the late 1970s (Chart I). At the time, the Fed had lost its grip on price stability for nearly a decade and living with high inflation had become a way of life. President Jimmy Carter appointed Paul Volker to take dramatic action. The Fed’s tough love ultimately pushed short term interest rates to 20% in 1981. Since then, inflation has been in check for nearly 40 years, coinciding with a long bull markets along the way for both stocks and bonds.
Responding to surging prices by talking tough, increasing short-term interest rates, and a few other maneuvers, should eventually slow consumer demand and halt the surging inflation before it becomes entrenched in our economy.
Chart I
Inflation – 1960-2022
* Source: The Federal Reserve Bank of St Louis and U.S. Bureau of Economic Analysis. The Federal Reserve’s preferred inflation gauge and described by the U.S. Bureau of Economic Analysis (BEA) as “A measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.”
Until the Medicine Takes
The Fed’s current decisive actions should ultimately lead back to a better environment for both businesses and markets. We applaud and are grateful for the Fed’s moves. They are making tough and unpopular choices that are both bold and necessary.
The Fed will continue to pay attention to the impact of their actions on inflation and adjust accordingly. Once the medicine starts to work, the financial markets should begin to breathe a sigh of relief and today’s uncertainty will begin to fade as it always does.
The medicine seems to be having an effect already. Companies’ guidance and stock valuations are beginning to reflect the fundamental impact of higher interest rates. The housing market is finally showing signs of cooling down as mortgage interest rates have more than doubled this year. Economic forecasting organizations, such as the Conference Board, predict that the U.S. is on the precipice of a mild recession based on the influence of persistent inflation and Fed interest rate increases.
Embracing Uncertainty
On one level, this year’s market decline is not fully surprising. Historic market data shows yearly average market returns in the high single digits. Most Rebalance portfolios have been appreciating in the “teens” for the last three years. Something’s had to give. But nevertheless, today’s markets are stressful to be sure. Given the current uncertainty, it can be hard to feel like an optimist. But most of what happens in our lives is unpredictable. Despite what some “experts” might claim, it is not possible to forecast the future.
In spite of the ups and downs in the financial markets, most of my clients find that they have a good investment experience without having to forecast what the market is going to do or trying to guess which companies will succeed and when. As a strategic asset allocation investor, harnessing the power of index funds, I believe in capitalism and the ingenuity of people to solve problems and make their companies run better.
I empathize with those of you feeling anxiety during these times. Seeing your retirement portfolios go down in value can generate fear and bring out negative emotions. We are all human after all. But it is important to remind ourselves that these are the times when having a long-term financial plan, and sticking to it, pays off.
As Chart 2 shows below, staying invested and sticking to a plan has worked out well over the last 70 years, including navigating through wars, recessions, bear markets, bubbles and busts. A simple indexed stock and bond portfolio has averaged nearly 9% annualized return and over 5, 10 and 20 year rolling average periods always has had a positive return.
Chart 2
We continue to hear from our clients that going through a thorough financial planning process has helped them live better during stressful economic times. While financial markets cannot be controlled, the risks you take investing can be managed. In the absence of a crystal ball, rebalancing your portfolio allows us to manage risk and take advantage of price dislocations that present themselves during volatile markets. As always, we remain patient, diligent, and focused on the long-term.
I like to work with two broad asset classes as the basic building blocks of my client portfolios: Growth and Income. During the third quarter of 2022 these asset classes performed as follows:
World Markets Review – Third Quarter 2022
World Markets
Growth Asset Classes
Large U.S. Stocks. Large-cap U.S. stocks fell in Q3 2022 based on continued high inflation readings, tighter monetary policy, sharply higher interest rates and the increasing chance of recession in the U.S. All of these factors weigh on the valuation of equities. The Federal Reserve emphasized it was going to get tough and stay tough on inflation during multiple public presentations within the quarter.
Small-Cap Stocks. Small company stocks fell during the third quarter based on the same forces pushing larger cap stocks lower and because they are less liquid and therefore more vulnerable to selling pressure.
International Developed Stocks. Foreign developed markets were particularly hard hit during the quarter. Foreign central banks that have been holding off raising interest rates are now being forced to do so to defend their currencies against a rapidly rising U.S. dollar. These interest rate increases may produce further slowing in the economies of developed markets outside the U.S. and pressuring stock prices.
Emerging Market Stocks. Emerging markets stocks fell sharply during the second quarter given the inflationary impact of weaker currencies on top of surging food and energy inflation.
Real Estate. U.S. real estate investment trusts (REITs) continued to be under pressure from sharply higher interest rates. This pressures REITs in two ways. Bonds become competitive to REITs for income-oriented investors and rising borrowing costs hurt real estate fundamentals.
Income Asset Classes
U.S. Government Bonds and TIPS. Yields on the benchmark 10-year Treasury rose markedly during the quarter with the higher inflation readings, causing prices to fall sharply across all maturities including inflation protected bonds (TIPS). The U.S. consumer price index rose year over year by 8.3% in August, continuing a streak of surging inflation readings in 2022.
U.S. Corporate Bonds. U.S. investment-grade (higher-quality) corporate bonds prices fell in Q3 as interest rates rose, the economy weakened, and credit concerns negatively influenced spreads and pricing.
High Yield Corporate Bonds. More speculative high-yield corporate bonds fell slightly during the third quarter based on increased credit risk and rising interest rate spreads vs. their less risky investment grade counterparts.
Emerging Market Bonds. Emerging market bonds fell sharply during the quarter, as higher U.S. interest rates and a strengthening dollar increased credit concerns for sovereign issuers who face higher repayment burdens when their local currencies weaken vs. the dollar. The U.S. dollar index climbed 17% in the third quarter vs. a basket of global currencies.
Preferred Stocks. As a “hybrid” security that is part fixed income and part equity, preferred stocks are influenced by forces influencing both stock and bond markets. In Q3 2022, preferred stocks produced a slight negative return but outperformed broad bond benchmarks.
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