Chief Investment Officer | Johnson Financial Group
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.
5 minute read time
Happy belated Halloween. I did not see any Federal Reserve Chairman costumes during the Saturday evening trick-or-treat outing in my area. No one seemed interested in taking on the likeness of Jerome Powell, the current Fed Chair. Why not? No one wants to be reminded how spooky the current economic environment might be.
The Fed’s credibility has been shaken as it hiked its' benchmark interest rate from 0% to 3.25%. Markets expect another 0.75 percentage-point hike from today’s Fed meeting, bringing us to 4%. They admitted that inflation is a bigger problem than it anticipated 12 months ago.
Where do we go from here? Should we worry about how high rates may go, and what do we do with our investment positioning?
We will gain insight into current Fed thinking today after its two-day meeting. The Fed may tell us inflation remains stubbornly high and it needs to see more economic data suggesting slower activity before putting a stop to hikes. Therein lies the problem with its policies. And this is not new. The Fed makes decisions based upon backward-looking data. Also, the Fed doesn’t have many tools available, and of the tools they do have, the level of interest rates is the biggest. This combination of old information and blunt tools means the Fed is usually late to raise interest rates to slow the economy…and late to lower them when it has slowed too much.
Last week’s personal consumption expenditure index (the Fed’s preferred measure of inflation) showed a year-on-year growth rate of 6.2%, with a core rate (excluding food and energy) of 5.1%. This was below the previous four-month averages of 6.5% and 4.9%, respectively. In other words, by the Fed’s own measure, we haven’t seen much progress. But then we shouldn’t have expected to—yet.
In the same report last week, we learned that personal spending grew by $125.5 billion, while savings grew by only 3%. What we’re seeing is the consumer continuing to spend. Some of that spending is due to higher prices, not additional consumption. In real terms, i.e., adjusted for inflation, spending barely grew.
The decline in the savings rate suggests that despite the strong job market, consumers are using existing savings to maintain spending, pointing toward an economic slowdown in the near future. Because the labor market is usually the last thing to weaken when the economy slows, we should begin seeing signs of weakness in 2023.
As mentioned, the Fed will announce its next rate decision today. The market expects another increase of 0.75 percentage points. Looking further ahead, the market expects the Fed Funds rate will get to 5% by the end of the first quarter next year.
Now let’s turn to the Treasury market and consider implications. The yield on the two-year Treasury is 4.49% today. This provides insight into how bond-market participants think the Fed Funds rate will change over the next two years, as market expectations for the future of the rate are built into its current pricing. The 10-year Treasury yield is 4.04%, lower than the two-year by almost half of one percent. When people refer to an “inverted” yield curve this is what they mean. The yield on shorter maturity bonds is higher than longer-dated ones. This indicates a market expectation for rates to move higher. How high can rates go?
Of course, we don’t know the exact amount. What we do know is that interest rates have risen considerably. We know the cost of capital for borrowers has risen and is having a desired slow-down effect. As an example, the average interest rate on a mortgage is over 7%, up from 3% at the beginning of the year. Not surprisingly, single-family home starts have declined almost 5%, and multi-family starts are down 13%. They are both down 20% from their April peak.
Home prices had been growing at an unsustainable clip. This increase in capital cost has caused that increase to stop and reverse course, its intended purpose. It will take time for higher rates to have their full effect.
While bond returns have been negative this year (prices retreated as interest rates moved up from the zero-bound), now bonds represent a more attractive place to invest. As an example, an ultra-short bond ETF has a yield of approximately 3.2%. A high-yield bond fund yields over 8.2%. An average investment-grade corporate bond ETF has a yield above 5%. These are merely examples to show that bonds can now add value to a portfolio; they aren’t specific recommendations.
We have been increasing our average bond maturity, where appropriate, as yields move higher. While we don’t know when the interest rate hiking cycle may end, we do know that bonds tend to perform better when the rate hikes conclude, as shown in the accompanying chart.
A portfolio of dividend stocks is also more attractive as prices decline. During recent bear market rallies, we’ve seen dividend and defensive sectors of the market outperform growth stocks. Defensive industries include pharmaceuticals, utilities, consumer durables and real estate. Some of these are more impacted than others by movement in interest rates. Focusing on companies whose free cash flow and earnings growth are less impacted by a weakening economy can provide some defensive posturing during a bear market.
The middle of a bear market is a trying time. Some might even say spooky. We don’t know how high rates will be raised, nor how much stock prices may decline. What we know for certain is that companies and consumers will adapt.
How do I know? Because over the last two pandemic years, that is exactly what all of us have had to do and have done so well. This is not to sound overly optimistic. To be sure, we have many areas of concern about economic and earnings growth. However, our long-term objectives cause us to focus on emerging opportunities.
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