October 1, 2022
The transition from the Federal Reserve’s economic support policy to economic restraint continues as interest rates rise at a rapid pace. The investment markets have been affected by the change, but the economy continues to be strong for now, despite negative GDP readings.
The GDP numbers say the economy is flat. The most recent report shows growth to be .6% lower last quarter following a 1.6% decline in the first quarter. Reported GDP, however, is adjusted for inflation, which can be measured in several different ways, and is also subject to adjustment itself. Unadjusted, current dollar GDP increased by 8.5%. The shorthand definition of a recession is two consecutive quarters of adjusted negative growth, but recessions are officially determined in hindsight by the National Bureau of Economic Research, after considering a number of different factors.
Whether there is currently a recession is probably a moot point, because we are certainly headed in that direction. The Fed is actively engaging in reversing its accommodative monetary policy. Leading indicators have dropped for the last six months, suggesting weaker activity ahead. However, the manufacturing and service industries’ purchasing managers’ indexes indicate continuing expansion, and employment remains strong. So while the financial numbers point to recession, the on-the-ground indications still show growth.
The stock market (S&P500 index) finished the quarter down 4.9%, after enjoying a summer bear market rally. Bond performance was even worse than stocks. The ten-year Treasury bond yield increased to 3.83%, translating into a loss of 5.7% during the quarter for bond-holders. The typical 60/40 stock/bond allocation portfolio and retirement target date funds continued to get hit from both directions as they have since the beginning of the year. Only the US dollar, money market funds, and some short-term Treasury notes have resisted the value destruction recently.
As long as the Federal Reserve continues its current policy, these trends may continue. However, the always optimistic securities analysts expect a 27% gain over the course of the next year, despite the fact that companies that have recently provided negative earnings guidance outnumber the positive guiders by 64 to 41. Martin Zweig’s time-tested advice, “Don’t fight the tape.” and “Don’t fight the Fed” is worth considering here.
We are in a complicated spot. The Fed maintained their easy money policy for too long, believing that inflation was either not a problem or would be "transitory" at worst. They are now scrambling to catch up by rapidly increasing the Federal Funds interest rate, which is the basis for all other kinds of interest rates in the economy, coupled with much tough talk. The talk is intended to restore their credibility, which was lost when the markets learned in the past that they would quickly reverse course when the political going got tough.
Adding to the problem, the new policy revisions came at a time when stock and bond markets were historically overvalued, which was a direct result of their old Quantitative Easing (QE) zero interest rate policy. They have effectively slammed that overvaluation engine in reverse, embarking on Quantitative Tightening and raising interest rates to put the brakes on rising inflation before it gets ingrained in continuing economic expectations. If the recognition of inflation becomes widespread again, it could lead to a self-accelerating spiral of higher prices, leading to higher wages and manufacturing costs, which then lead to even higher prices and wages and costs, etc.
Where are we now? Typically the interest rate of 2-year treasury debt is less than that of 10-year debt. When the Fed raises rates to cool a hot economy, the 2-year rate can rise above the longer-term rates. This condition is called an inverted yield curve. It is a leading indicator of recession, which typically follows 3 to 12 months after the inversion ends, so there still may be some time before the economy slows. In addition, Fed policy changes take between nine months and two years before the results become evident in the economy. We are about nine months into that process now. Although a slowdown is likely on the way, employment and corporate profits are still strong, calling into question some current opinions that we are in recession right now.
The Fed says that they intend to bring inflation down to their target rate of 2 to 2½%. It is generally thought that in order to keep inflation in check, the Federal funds rate needs to be above the inflation rate by at least the historical average of 1%. That implies an on-going federal funds rate of perhaps 3½%, which means higher consumer rates for financing mortgages, cars, credit cards and the like. Interest rate futures suggest that the fed funds rate will peak at about 4.55% in March of 2023. If this expectation is true, and the end of a potential recession and the stock market bottom lag the rate peak by several or more months, we could have a lengthy period of lower stock returns. Of course there is always the possibility that the Fed goes back to their old ways before then, reversing course before knocking inflation back. This outcome could could prompt stocks to resume their rally on the renewal of an easy money policy. Unfortunately, the effect of an early reversal could repeat the result of the policy mistakes that led to the extensive inflation of the 1970’s.
The lack of a current recession is good from the point of view of a wage-earner, but not necessarily for an investor. The stock market is a leading indicator of the economy, because it responds negatively to tightening credit conditions in real-time. The starting point for today’s stock and bond market declines was historical over-valuation, so there is more room to lose value even before a recession starts. It is our belief that the current decline has been simply a result of a partial correction in valuation due to higher interest rates, rather than the markets’ factoring in a recession.
Since the economic effects lag Fed policy for months, the Fed is driving down the economic road in a fog. They know there may be a cliff ahead, but they do not know where they are in relation to it. As a result, typically they continue a monetary tightening policy until something in the economy visibly "breaks", like the financial crisis which occurred after the Lehman Brothers collapse in 2008. For now, we might expect that higher rates will continue to reduce stock and bond valuations, keeping pressure on the markets, but it is not until the tightening pressure causes the failure of some weak link in the economic chain to fail, that the bear market becomes really serious. This possible result is not considered in the forecasts that suggest the bear has perhaps another 10% to go, although from a technical perspective, this would be a logical place to pause for days or months, since it is near the peak value before the 2000 crash.
From an investor’s viewpoint, that may perversely be a good thing, because it would reset valuations. Even at current levels, returns for the next decade can be expected to be minimal, because the markets remain expensive. If economic conditions revert to a "normal" level, future returns have a better chance of becoming "normal" again, providing opportunity for new investment at lower prices. Additionally, the prior Fed policy encouraged companies and the government to take on additional debt and increase investment risk. This was paid for by would-be low-risk savers who have earned next-to-nothing on their deposits since 2009. Current policy is once again providing a reasonable return in money-market and high-yield savings accounts, albeit still less than inflation.
Should the Fed win the inflation battle, it will reduce interest rates again, longer-term bond yields will also drop and bond investments will rise. Stocks should also benefit from renewed lower rates. If a recession occurs during the process, investors will find lower entry prices and a better return outlook when profits turn up again.
From a financial planning and execution viewpoint, complacency could be detrimental here. Actively following a financial plan that maps your path to your future goals and guides your spending, saving and investing accordingly, while always important, is likely to be even more relevant today.
David C. Linnard, MBA, CFP®
LINNARD FINANCIAL MANAGEMENT & PLANNING, INC.
46 CHESTER ROAD
BOXBOROUGH, MA 01719
Barbara V. Linnard
A Registered Investment Advisor and NAPFA-Registered Financial Advisor
The contents of Outlook & Trends reflects the general opinions of LFM&P, which may change at any time, and is not intended to provide investment or planning advice. Such advice is only provided by means of individual agreement with LFM&P.