Since the beginning of the year, the markets have been rattled by persistently high inflation and the question of how the Federal Reserve might respond.
In March, it began with a simple 25 bp (bp = basis points, 25 bp = 0.25%) rate hike in the fed funds rate to a range of 0.25%-0.50%.
Unlike the rate-hike cycle of the 2000s and the very gradual increases in the 2010s, inflation is a big problem today.
We are receiving comments from key Fed officials that “it is of paramount (my emphasis) importance to get inflation down" (U.S. Federal Reserve Governor Lael Brainard - Wall Street Journal).
Or: Today’s high inflation “is as harmful as not having a job…. If you don’t have the confidence [the Fed will use its inflation-fighting tools], let me give it to you" (San Francisco Fed President Mary Daly - CNBC). So we can’t expect the baby steps we’ve grown accustomed to.
This IS your father’s rate-hike cycle
Based on commentary from most Fed officials during April, shock and awe is the most likely approach. One closely followed measure from the CME Group suggests a 0.75% rate hike in mid-June, and another 0.50% in July. The Fed raised by 0.50% on May 4.
That is to say, we may see the most aggressive pace of tightening in almost 30 years.
An aggressive tightening cycle can generate volatility in two ways.
First, higher interest rates compete more effectively for an investor’s dollar, siphoning cash away from stocks. Second, higher interest rates can slow economic growth, which may put the brakes on profit growth.
In addition to higher interest rates, the Fed is set to let the bonds it purchased in 2020 and 2021 runoff its balance sheet in a measured fashion. In other words, investors are not only grappling with higher interest rates, the runoff in bonds may create additional obstacles.
Performance bears this out. With four months behind us, the S&P 500 Index is off to its worst year-to-date start since 1939, according to Dow Jones Market Data (WSJ).
Table 1: Key Index Returns
Dow Jones Industrial Average
S&P 500 Index
Russell 2000 Index
MSCI World ex-USA*
MSCI Emerging Markets*
Bloomberg US Agg Bond TR USD
Source: Wall Street Journal, MSCI.com, MarketWatch, Morningstar
MTD returns: Mar 31, 2022-Apr 29, 2022
YTD returns: Dec 31, 2021-Apr 29, 2022
*In US dollars
And fears are rising that the Fed’s new-found inflation-fighting backbone might choke off economic growth. Should we be concerned?
GDP unexpectedly contracted in Q1 at an annualized pace of 1.4%, according to the U.S. BEA. But the decline was related to one-off factors.
During Q4 2021, GDP surged 6.9%—also due to technical factors. We believe it’s better to average the last two quarters. Besides, an acceleration in consumer and business spending during Q1 was encouraging.
Here are a few other encouraging stats.
An astonishing 1.7 million jobs were created in the first three months of the year, per the U.S. BLS.
First-time claims for unemployment insurance are hovering near the record low set in the late 1960s—records date back to 1967 (Department of Labor). Further, business openings are at a record high (U.S. BLS), in part because business activity has been strong.
We wouldn’t be seeing these numbers if the economy were contracting.
Let’s look at some of the anecdotal evidence. If the economy is weak, consumers shy away from discretionary purchases. When it comes to travel and entertainment, that’s not happening.
Airlines are seeing strong demand (CNBC), and an April 23 story in the Wall Street Journal highlighted aggressive pricing for summer concerts as fans eagerly line up to buy tickets.
Here’s an interesting remark from the CEO of McDonald’s, who said the consumer is in “good shape” because customers are still ordering items for delivery, the most expensive way to buy due to the hefty convenience fees (CNBC).
Put another way, we complain about inflation, but we complain while in line to make a purchase.
Still, stimulus money stashed in savings accounts may be aiding overall spending, which may be artificially supporting growth. Per U.S. BEA data, incomes are not keeping up with inflation, which could eventually create resistance to higher prices just as the Fed is lifting rates and raising the cost of money.
What will it take to stabilize the market?
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.
Are we at or near a bottom? We don’t try to call bottoms or tops, and that articulate analyst on the financial news network may be smart, but they don't have a crystal ball. Our view is now is not the time to try to be a hero and it probably is wise to be a little cautious.
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.
Powell and the Fed 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. Today, new Covid lockdowns in China are exacerbating problems.
We do not believe investors should be taking outsized risks. Successful investors are disciplined. They refuse to let excess optimism or pessimism guide their decisions and instead look at their long term financial plan.
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.
If you have questions or would like to talk, we are only an email or phone call away.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Economic forecasts set forth may not develop as predicted.
Asset allocation does not ensure a profit or protect against a loss.