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The Fed Slams on the Brakes

We’ve had many client conversations over the past several weeks about portfolio strategies in light of recent market conditions. And rightly so. After a brief lull in July, market volatility returned in August and has increased of late, leading many clients to wonder what is driving all this volatility and what are the impacts on my overall financial plan?

On Wednesday (9/21) the Federal Reserve’s Open Market Committee (FOMC) voted unanimously to lift their benchmark Fed Funds rate another 75bps (0.75%), bringing it into a new target range of 3.00-3.25%, a level last seen in 2008. This rate move was anticipated by most investors. What wasn’t anticipated as much was the future direction of Fed Funds rate policy that Fed Chairman Jerome Powell described in the post-meeting news conference. In it, he described a path of additional aggressive rate hikes leading to a range of between 4% - 4.5% by the end of 2022 and a period of “below trend” growth.
Blame the August CPI report for that. Headline year-over-year (YoY) CPI came in hotter than expected (8.3% vs. 8.1%), even though that was less than July’s reading of 8.5%. Falling energy and gas prices were not enough to offset price growth in so-called Core CPI, which excludes the effects of more volatile Food and Energy). Strong gains in rents and services among other categories pushed Core CPI up to 6.3% from 5.9% the month prior. All this to say that inflation is proving to be very stubborn, and the Fed has fully committed to bringing it back closer to its stated “2%” average target, even if that means some economic pain in the short term.

“We have to get inflation behind us,” Powell said on Wednesday. “I wish there were a painless way to do that. There isn’t.”

Markets reacted rather decisively after Powell spoke. The S&P 500 index of large cap stocks was up ~1% most of the day in Wednesday trading, then fell after the news conference to close the day down 1.7%.  From a financial theory perspective, this makes sense. Higher discount rates translate into lower stock prices today as the future cash flows of companies are worth less and less than those in the near term. Also, the costs of doing business are higher, leading to potentially a slowing of corporate earnings’ growth. All this leaves the S&P 500 (large cap stocks) and Russell 2000 (small cap stocks) indexes down a bit more than 20% this year. The Nasdaq 100 index of growthy tech stocks is down 30%.

In bonds, the Treasury yield curve has been inverted for some time now. Short-term (1- and 2-yr) Treasury yields rose to 4%, while the yield on longer duration 10-yr Treasuries pulled back to around 3.5% as investors bet the Fed’s hawkish stance will eventually succeed over the longer run, even if there is some economic pain required to achieve the goal of lower inflation. The Bloomberg US Aggregate Bond index is down 13% for the year (prices move inversely to yields).

Mortgage rates for housing have recently hit 6.29%, continuing to raise the costs for home buyers. Existing home sales dropped nearly 20% in August over the prior year, making this the seventh straight month of declines. Powell indicated the housing market could continue to soften in the months ahead as borrowing rates are likely to remain elevated.

Following the Fed’s decision, the Bank of England, the Swiss National Bank, and other central banks also raised their benchmark short-term rates. Inflation is not just a U.S. problem. Global demand for US Treasuries remains strong, given the relative level of interest rates in the U.S. on offer vs. other countries’ rates. This has driven the US Dollar to its strongest levels in over 20 years vs. most of the world’s major currencies (EUR, GBP, JPY). The Euro trades at less than $1 for the first time since the early 2000’s, and the Pound is closing in on parity too.

Bear markets are painful to live through, even if you’ve experienced them before. But because we know bear markets are a normal part of long-term investing, we prepare in advance for them by setting investment strategies for your portfolios that recognize risk is always present in the markets. The key questions are, therefore, How much risk you can tolerate? and How much risk you need to take to support your goals?
Jack Bogle, founder of Vanguard, has often said the best thing diversified investors can do is to “stay the course”. That’s because we’ve already factored in the probability of bull and bear market scenarios into the strategy and construction of your portfolios. So, therefore, we need to remain disciplined within our risk-adjusted investment strategies and avoid the temptation of market timing. Our strategies are set to capture the market returns where and when they arise.

But still there is the very human feeling of needing to do something in these situations. Extended market downturns are a good time to reassess your risk tolerance and your ability to sleep comfortably while remaining invested. Adjustments to portfolio strategy should be made if you are unable to actually stick to it in a downturn. Assuming you’ve got sufficient liquidity to cover short-term needs, we rely on long-term market compounding of returns to generate growth in the portfolio.

At BAM, when markets become more volatile, we do more frequent portfolio reviews, rebalancing as needed, to ensure they are maintaining their strategies. We also do Tax Loss Harvesting (TLH) in taxable accounts where and when we can capture capital losses that can offset gains elsewhere in the portfolio or be used partially against income and carried-forward to future years. In addition, we review financial plans and assumptions with clients to keep focus and perspective on the goals that matter to you.

We know that markets can go up and down over short time frames, often unpredictably. While this feels uncomfortable and stressful, it is normal market behavior. Uncertainty is part of investing that we must factor in. Over longer time periods stocks have outperformed all other major asset classes and inflation.

The bear market of 2022 has thus left us with higher expected returns on stocks for the future. We are seeing higher dividend and bond yields providing more income for portfolios than in recent memory. Yields on short-term debt are 4% and interest on bank savings has been rising to 2%, both great options for cash.

While the Fed has made very clear its aggressive stance to combat inflation, which has led to continued market volatility and uncertainty, we also know that markets can change course quickly as new information comes available. Earlier this year, we wrote about bear markets and their eventual recoveries as well as why usually this time is not so different. Long-term investing remains one of the best strategies for achieving your financial goals.

Now may be a good time to discuss your portfolio strategy or financial plan. Please don’t hesitate to reach out to us.
Thanks for reading.