“The Federal Reserve needs to raise rates as quickly as possible to tame inflation by sending us into a recession, where they can then cut rates to save us from the recession”.
-Ben Carlson@awealthofcommonsense.com
The above quote by financial author and podcast host Ben Carlson describes the unenviable position the Federal Reserve is currently in and the continued challenge it faces in taming inflation.
The quote might sound humorous and a bit ridiculous, but it does highlight the very issue that has plagued stock and bond markets all year -will the Fed make a policy error and raise rates too aggressively tipping the U.S. economy into recession or will they be able to thread the needle and raise rates just enough to cool consumer demand and therefore bring inflation back in check?
That’s the million-dollar question and at this point it would be premature for us to make assumptions either way. We do, however, fully expect the Fed to raise interest rates another 75 basis points or .75% on July 27th and could then pause on a September rate hike depending on how the economic data shakes out over the next couple months. Remember, each rate hike takes time to work their way into the financial system in order to create their intended affect.
As I mentioned in my May 2022 note, we were seeing indications that inflation had or was largely in the process of peaking. Since then, we are seeing additional data from May’s declining consumer spending, housing, and manufacturing reports that are confirming the economy is slowing quicker than expected which should result in reduced inflationary pressures overall and the equities market seems to be sniffing this out with a shift from inflation fears to recession fears.
The next CPI (consumer price index) release is next Wednesday, July 13th and we are hoping to see the evidence reflecting this. If inflation is trending lower, then the Fed may not need to continue the same aggressive interest rate hiking trajectory that both the stock and bond markets have already baked into current valuations. Which means certain asset classes (mainly growth stocks and intermediate to long duration bonds) may be priced too bearishly given a less aggressive Fed. This scenario could be unfolding now given the recent market upswing (specifically within the NASDAQ Index) over the last three weeks.
If we had to choose between the lesser of two evils, we would choose a recession over runaway inflation. This morning’s non-farm payroll report showed the U.S. economy created 372,000 jobs last month with an unemployment rate of 3.6% and another 11.3 million job openings still available. If we do tip into recession (which we may already be in), it will be a technical recession -one in which, for the first time in history, jobs will be added (net/net) to the economy. Meanwhile, inflation will be trending back down to where it needs to be.
As you know, the first six months of this year have been challenging (to say the least) with the S&P 500 Index reflecting a -20% loss and the Barclays U.S. Aggregate Bond Index down -10.35%. The worst first half performance in 52 years.
Tactically, given the information laid out above, what actions have we taken in portfolios to mitigate downside volatility (as much as possible) and to take advantage of the inevitable market recovery?
Several months ago we liquidated two of our largest Fixed Income mutual fund holdings for two reasons. First, we started to see opportunities in individual bonds where we are now able to replace the mutual fund holdings by purchasing individual corporate bonds at PAR or below, with attractive coupons and limited duration. We can then ladder the bonds with consecutive maturity dates, capitalize on higher coupons and mitigate interest rate risk. Given the Feds upcoming interest rate increase on the 27th, it will pay to purchase these bonds over time.
Second, given the simultaneous decline in both stock and bond markets we wanted a higher cash allocation across portfolios to take advantage of this decline to buy both stocks and bonds at lower prices.
In periods of a secular decline in markets patience is imperative. We do not want to catch a falling knife and over the last 3 months it has not paid to buy the dip. The are times when markets become oversold in the short run, then rally, only to sell off to new lows and we have seen this take place numerous times this year.
We remain patient, wait for clarity and the various macro headwinds to clear, then look to meaningfully buy/add to existing portfolio positions and rebalance. Of course, we will never be able to call the market bottom but over the coming months, we will be putting cash back to work selectively. Hopefully avoiding the falling knives and market head fakes and positioning our clients to benefit from the inevitable market recovery.
We wish you and your family a great Friday evening, and a wonderful weekend!
As always, please reach out to us with any questions or comments you may have regarding your specific situation.
Jaran C. Day, Chief Investment Officer
Griffin Dalrymple, CFP®, Chief Strategy Officer