The Fed Moves and What It Means
5/2022
Welcome to 2022. Since the beginning of the year, the market has experienced more than its share of turbulence. As of the end of April, since it’s high, the S&P 500 was down 13%, the NASDAQ was down 21%, and the Russell 3000 was down 15%. Not to be left out of the fray, the bond market was down almost 10%.One of the reasons the market has fallen is because of the rise of interest rates. Year over Year inflation measurements has spiked to above 9%. The 10-year yield has gone from almost 1.5% to above 3%. This has caused forward looking valuations to most of the high price stocks in the NASDAQ to fall. This could be due to the fact that investors invest in stocks expecting a return. That return usually is priced off the forward cash flow of the dividends received from the investment. As interest rates rise, that dividend flow has less value, hence, the price of the stock this lowered. Remember that the market has experienced a large rally over the past two years, since the bottom that was induced by the pandemic in the spring of 2020. It is only natural to expect that some of that would be given back over the course of time.
The bond market has not been immune to this sell off either. Normally the fixed income investments in a portfolio is held to provide a consistent return and to try to buffer any sell offs on the equity side. Unfortunately, because of the easy monetary policy of the Federal Reserve, interest rates were extremely low. They were not able to offer protection because they also are beginning to normalize. The Federal Reserve has undertaken the most aggressive pace of tightening in 30 years and will probably continue to raise short term interest rates until they get up towards the 3%-3.25% level on Federal Funds. At that point. they will probably pause and watch to see what effect that has on the economy, credit markets, dollar, and global interest rates. All of these are intertwined. The pricing of short-term interest rates on the CME shows that participants expect the Federal Reserve should be done tightening going into the summer of 2023, will have a pause until winter of 2023 and then market participants are actually expecting the Federal Reserve to ease. I would expect that the long end of the yield curve (from 10 years to 30 years) will stay relatively close to the area of 3.50%. There may still be a small back up to the 4% level.
High inflation, worries about the Fed, slowing global growth, and the ongoing war in Ukraine are well known. The pullback in stocks reflects the high level of negative sentiment, and at least in part, stiff headwinds are already priced in.
Let’s share some thoughts about various possibilities. If Russia were to suddenly end its hostilities in Ukraine, a significant short-term headwind would be eliminated. Sadly, this best-case scenario, which would end the needless suffering in Ukraine, is highly unlikely. More realistically, investors want signs that inflation is not only peaking but on a downward path. Why? It would reduce the need for steep rate hikes. Fed President Powell and the Federal Reserve are hoping to slow inflation without tipping the economy into a recession. But they will need skill and some luck. For starters, the dollar is flexing its muscle on foreign exchanges. A strong dollar may reduce import price inflation. But the Fed will need more help from the supply chain, which has been slow in coming. The rate of change in inflations should begin to improve in the coming months. Inflation numbers began to ratchet up last summer and the year over y=ear numbers will begin to reflect that. While the rate if inflation should slow, the level of prices probably won’t fall, especially given the wage increase that have been imposed in the workplace.
I do not believe that we are entering into a sustained bear market in equities. I believe that this is more of a revaluation of where prices should be. They are reflecting the expectations of investors over the next five years. The return of the equity market should not be as outsized as it has been the previous two to three years. Even with the selloff in the equity markets, the indexes are still above the highs before the pandemic occurred. The indexes are back to levels that they achieved 18 months ago. The froth, as it is sometimes called, has been taken out of the market. Investing is a journey not a destination. The ups and downs of market movement are normal and to be expected, If you look back over the course of history, you will see that there is usually a 10 to 20% correction in the index every 14 to 19 months.
I do not believe investors should be taking outsized risks. Successful investors are disciplined. They refuse to let excess optimism or pessimism guide their decisions. It is time to employ a disciplined approach and maintain recommended asset allocations. Just as these ‘guardrails’ can keep you from lurching into riskier assets when stocks are quickly rising (and we feel invincible), the parameters are also in place to prevent emotion-based decisions that can sidetrack you from your long-term goals.
If markets continue to slip shorter-term, rebalancing helps add to your positions when stocks are down, i.e., buying low.
The opinions expressed herein are those of Riverbend Planning Group. The data and opinions are furnished for informational purposes only and should not be considered a solicitation for an investment decision. Although it is derived from sources believed to be accurate, Riverbend Planning Group makes no guarantee to the accuracy of the information
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