Today, the Federal Reserve announced a 0.75% interest rate hike, moving quicker and more aggressively than previously anticipated to combat inflation (more on that below). We believe this is a step in the right direction, but markets are still worried that quick rate hikes will crush demand and cause a recession. The push and pull between slowing inflation and keeping the economy growing may end up being too fine a line to walk, but we believe this move instills confidence that the Fed is not asleep at the wheel. They are slamming on the gas pedal hard and adjusting to stubborn inflation data from just last week. Hopefully they can switch gears and slow down when the time comes in a similarly fast manner.
The higher magnitude in the Federal Reserve’s rate increase is partially due to last Friday’s hotter than expected inflation data. The Consumer Price Index data showed that inflation may not have peaked after all. The country is still struggling with rising prices across a wide array of goods and services. Investors were worried leading up to the release of data, and the selling continued before today’s welcomed meeting.
Stocks prices are fundamentally supposed to represent a company’s future cash flow expectations. There are two major headwinds affecting stock prices and causing the dramatic drops we are seeing these last few weeks. First, higher interest rates will mean higher costs of doing business for companies and individuals that take on debt to grow or buy a home for example. Second, if a recession is coming, demand for goods and services could dry up, and revenues should come down. Investors are overlooking a tight labor market, with more openings than people looking for work, and the fact that the consumer balance sheet has rarely ever been stronger. If we do not get a recession and company earnings remain stable, stocks could be undervalued and pricing in a “worst case” scenario. Inflation should come down naturally as supply chain logjams work themselves out. The Fed was clearly too late to act, but hopefully they can engineer a soft landing and avoid tipping the economy into recession.
Unfortunately, there has been no place to hide as bonds are also off to one of their worst starts to a year, ever. Normally a haven in times of equity market stress, bond yields have risen dramatically as the Fed has shifted policy, which causes bond prices to drop. At some point, investors will see value in a two-year treasury yielding over 3.2%. This could signal some sort of capitulation. Another sign of capitulation could be short-term volatility spiking – thus far, the selloff has been rather orderly with very few “wash-out” days. We are never ones to time the market, rather situating investments in companies we believe have more predicable cash flows in stable lines of business. This has worked to our benefit as “story stocks” from the pandemic heyday are experiencing the most pain.
Regardless of what happens in the near term – think the next couple of months – we need to remain levelheaded and cautiously optimistic because a recovery will come eventually, and markets will likely be higher in the coming years. The dawn is always darkest just before the day. For longer term investors, these volatile times can be a buying opportunity and for those taking cash flows, we have planned for this volatility by diversifying. While these times are never easy to go through, they are part of the normal course of the business cycle and can serve as an adjusting mechanism for valuations and overall market fundamentals.
As always, we are here for you if you have any questions about your portfolio or want to discuss the current state of the economy in more detail.
Withum Wealth Management Team