After years of markets rising on historically low interest rates, low inflation, and an extremely accommodative Federal Reserve (Fed), we are now seeing how assets prices can be negatively impacted by rising interest rates and restrictive Federal Reserve policy. For more than 10 years, stock prices increased unimpeded by high interest rates or soaring inflation. But all that began to change as we ushered in 2022 and inflation rose persistently higher than the Federal Reserve had expected.
With the prices of all types of goods and services rising, the Fed pulled out its anti-inflation playbook, a series of interest rate increases, in an attempt to combat, among other things, the above-average demand fueled by an excessive pandemic stimulus, an unwinding of the loose monetary policy in play for the most part of the last decade and accelerated through the pandemic. In an abundance of caution the Federal Reserve felt it best to keep interest rates low in order to keep the economy afloat through the uncertainties wrought by pandemic-related shutdowns. But in hindsight, their decision to continue to spur the economy in 2021 has only made it more difficult to slow inflation in 2022.
Risk attitudes and appetites
Lower interest rates impact the demand for, and price of, risk assets. The on-off attitude toward risk in the market has been directly related to the Fed’s interest rates moves. Currently, with the yield curve inverted, the bond and stock markets are more competitive than they have been for the last decade. For example, this is the first time since 2007 where investors can acquire a risk-free rate of return in a two-year bond in excess of 4 percent. With the perception of risk in the market, short-term investment could move toward the safety of the two-year government bond to avoid “risky” stocks, or even longer-term bonds.
Any reversal of the current trend will be related to a decline in inflation. Once prices begin to move downward, which, some argue, has already begun, the Fed won’t need to talk so tough about interest rates. This could create a significant rally in the markets, in particular for risk assets. We did experience a substantial bear market rally from the June 16, 2022 lows through mid August. The rally was brisk, the catalyst, an expectation of declining inflation and in turn interest rate hikes. But investors’ sentiment changed abruptly as Fed Chairman Powel spooked the markets by warning of “more pain” to come before rates could decline. The result: more increases in a variety of rates, particularly the one-, two-, three-, and five-year Treasuries to above 4 percent (as of September 28, 2022).
When bad news is good news
Financial markets are forward looking, and even though corporate profits have risen year-to-date, the markets are currently speculating a decline in those profits, which we might or might not eventually get. When we see a measurable reversal of prices and interest rates, we will see a much more bullish scenario for markets—and perhaps a softer landing for the economy than some economists predict.
But for now, bad news is good news. The markets are trading positively on bad economic news. For example, when the monthly Bureau of Labor Statistics jobs report shows higher than expected new job numbers, it is perceived as inflationary and in turn the market moves negatively. But if key economic indicators are negative, they signal a slowing economy and a related decline in inflation and various interest rates. Markets are extremely data dependent currently, and when the data shifts we should see more optimism in equities markets.
In summary, the longer inflation persists the more damage there is to be done by higher interest rates; the faster inflation declines, the quicker we’ll see a rebound in risk assets.
Stick with your plan
What can we do as investors? You might want to revisit your personal financial plan with your financial advisor. Most of the time, simply revisiting your plan will give you the confidence you need to keep emotion out of your investing and stick with your long-term plan. Your HBKS financial plan is designed to account for market volatility.
This time is no different than other periods of depressed stock prices. We will ultimately look back at 2022 as a volatile market environment that created long-term opportunities.
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