What is Happening in Stock and Bond Markets?

by | Dec 20, 2022 | Uncategorized

What is Happening in Stock and Bond Markets?

The stock market has been volatile lately because there is a competing narrative between the Federal Reserve (the Fed) talking tough about raising interest rates until inflation is reduced to its 2% target and investors who generally think the Fed will begin reducing interest rates sooner than it is willing to admit (because interest rate hikes already implemented will slow the economy sufficiently for inflation to drop).

Fed Policies and Credibility

The Fed has been aggressively raising short-term interest rates to slow demand for goods and services that ultimately reduce prices. Although the Fed would like to avoid pushing the US economy into recession, they claim they are willing to do so for achieving 2% inflation.

The Fed desperately wants to restore some of the credibility it lost when it mistakenly called inflation transitory and responded too slowly in raising interest rates and ending quantitative easing (printing money).

Several highly-regarded economists believe the Fed is now overcompensating for that policy error. They say the Fed is focused on stale data from the past rather than forward-looking data showing that the economy is already slowing and inflation has been squelched.

However, credible evidence is available that supports both narratives, making it unclear which path is correct. Most likely, the answer lies somewhere in the middle.

Despite appearing self-assured on television, the reality is that the Fed never really knows what needs to be done and in the right amount. Interest rate changes take many months to work through the economy, so patience is required and it is easy to overdo changes in either direction.

The Fed is under tremendous pressure and has a mixed record of doing the right thing. For example, the Fed contributed mightily to our current inflation problem with excessively low interest rates and expanding the money supply too much and for too long.

In addition, the Fed has a long history of caving to market pressure, meaning the Fed has changed course in response to sharp market sell-offs.

Market Reaction

The market was not expecting the Fed to be quite as aggressive when they raised the federal-funds rate to a range of 4.25%-4.50% on December 14. The federal funds rate is the interest rate charged to lending institutions, such as banks, on unsecured loans that are borrowed overnight. It serves as a benchmark on which many other rates are set.

To make matters worse, 17 of the 19 senior Fed officials believe that the federal-funds rate will need to go above 5.00% and stay at that level for a longer duration to sufficiently fight inflation.

Higher interest rates, along with the continuation of the Fed’s $95 billion monthly bond-selling program, which is designed to reduce the money supply and remove liquidity from the financial system (reversing previous quantitative easing), is not a positive backdrop for stocks. Hence, the sharp selloff on Wall Street between then and writing this note on December 19.

Each time the Fed affirms its tough talk, such as saying they are committed to raising rates until inflation is 2%, no matter what happens to unemployment, as they reiterated on December 14, investors worry that the Fed might be making a mistake in being overly restrictive, causing a recession or a deeper one than necessary.

The Economy

The housing market appears to be in a recession, as a result of dramatically higher mortgage rates from the Fed’s restrictive monetary policies.

Housing market struggles combined with the continued atypical inversion of the Treasury market yield curve (in which short-term interest rates are higher than long-term rates) and the drop in the price of oil on possible demand concerns, suggests that the U.S. is heading toward a recession next year.

The biggest counterpoint to the bearish economic outlook stems from the jobs market. In the US, and much of the rest of the developed world, employment remains very high.

Should the economy slow sufficiently to reduce inflation, interest rates will need to fall. Falling interest rates leads to bullishness in stock and bonds. In that way, under current conditions, bad news about the economy is sometimes good news for investment valuations and vice versa. This explains why the stock market declined on recent news of a stronger than expected jobs report, for example.

Recession in 2023?

Despite the Fed forecasting 0.5% GDP growth in 2023 (no recession), the Fed’s labor market outlook indicates otherwise.

The Sahm Rule is a relatively new Fed model, which has correctly predicted the last nine recessions and done so much faster than they were officially declared. The recession alert is triggered when the three-month moving average of the unemployment rate moves over 0.5% above its lowest low of the last 12 months.

The current 12-month low in unemployment is 3.5%. So, if the 3-month average climbs above 4.0%, that would suggest the economy is in a recession.

The Fed is predicting an unemployment rate of 4.6% by the end of 2023, conflicting with the Fed’s forecast for 0.5% growth.

Therefore, if the Fed continues raising interest rates until unemployment reaches 4.6%, we are likely to have a recession. The question is whether the Fed takes that path or circumstances result in them changing direction.

The Bond Market is betting that the Fed will not follow through and will ease sooner than their talk suggests. Herein lies part of the Fed’s credibility problem. Long-term interest rates are set by the market, not the Fed. Because the market expects easier conditions in the future, long-term interest rates are lower than the Fed would like.

Where to Invest?

With the last 12-month consumer price index showing inflation is currently 7.7%, investors cannot preserve their purchasing power with interest earned on bank deposits or investment grade bonds.

Owning stocks in companies that can raise prices and preserve their profit margins continue to offer the best chance of outpacing inflation over long periods. Firms with a history of success during periods of economic weakness are especially appealing now.

Nevertheless, Wall Street consensus is calling for negative earnings growth in S&P 500 companies next year and, should that happen, it will likely put downward pressure on valuations.

Although it is possible that the economy weakens more than expected, causing the Fed to reverse itself by cutting interest rates, we do not think there is adequate compensation for the credit risk and interest rate risk in intermediate and long-dated bonds now.

As you may recall, when interest rates rise, bond values decline. When interest rates fall, bond values rise. The longer time to maturity, the more bond values change in response to changes in interest rates.

With China ending its zero-Covid policy, reopening their economy could stoke demand for commodities and, in the process, put more upward pressure on inflation. A reopened China could keep the economy humming above recession levels for longer, while pushing prices up at a rate that forces central banks to stay aggressive.

That might mean a pleasant surprise for corporate earnings (which would also be helped by a weaker dollar flattering US companies’ overseas earnings). It could do considerable damage to the portfolio of anyone who had bought a lot of intermediate and long-dated bonds.

Therefore, in this environment, we focus on very selectively owning high-quality stocks and short-term bonds.

What to Expect?

Volatility: The uncertainty stemming from competing narratives between tough Fed talk and markets expecting otherwise means that we can expect higher than usual volatility. This is further compounded by factors such as the pace of China’s economy reopening and the war in Ukraine with its impact on food and energy costs.

Because markets are forward looking, values tend to rise ahead of economic growth and associated rise in company earnings. If we wait until all indicators are positive, we will likely miss a significant rise in valuations.

Regardless of whether we have a recession, investors remain likely to be better off in the long run by staying carefully invested in selected stocks for long-term needs.

Being in cash provides the illusion of maintaining your money, but is certain to lose value (purchasing power).

Need help with your investments?

I create custom investment portfolios for people investing at least $1 million.

Portfolios are comprised of selected stocks and bonds (not funds) according to each client’s goals and preferences, such as low volatility, dividend income, growth and my research.

Have questions? Call me at 201-266-6829 or email jeff@fintegrity.com.

 

 

Risk Disclosure: Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results.

This content may contain projections, forecasts, and other forward-looking statements that are based on hypotheses, assumptions, and historical financial information. The content is developed from sources believed to be providing accurate information; no warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability, or usefulness of any information.

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