Can a Credit Crunch Be a Positive for the Markets?
Yesterday the Federal Reserve (Fed) raised its policy rate by a quarter-point and signaled that the central bank was open to pausing rate hikes sooner rather than later. And while just a month ago it seemed like policymakers were going to keep interest rates higher for longer, the fact is that a lot has changed in the past few weeks.
Indeed, given the events unfolding with the likes of Silicon Valley Bank, Silvergate, First Republic, Credit Suisse and others, it’s quite possible to say that the Fed has met its objective to cause “pain” as systemic concerns and the risk of recession are all but assured in the current economic environment.
So, what’s changed in the past couple of weeks to cause such an about face with respect to the interest rate outlook for 2023? Certainly, just a month ago we were expecting higher rates for longer throughout the course of this year.
Even so, what’s likely changed the rate calculus is what could be the beginning of a credit crunch-induced economic recession.
Now, you’ll likely recall that Fed Chair Jerome Powell drove home the point of bringing economic “pain” during his comments at the Jackson Hole Economic Symposium last summer. Back then, the Fed had aggressively raised interest rates and the markets were hoping that the velocity with which policy was implemented at the time would usher in a rate pause from the central bank.
Nevertheless, with consumer spending and the jobs market still strong, it was clear that the fight against inflation was not over. In a sense, policymakers were desperately trying to jawbone, or talk down the economy, in a bid to get inflation under control. Even so, the Fed ended up raising interest rates another 9 times, leading to one of its quickest periods of rate hikes than we’ve seen in recent history.
With that said, the trouble with the Fed’s policy was that no matter how much it communicated how high rates might need to go, demand in the economy remained solid. That’s because household spending shifted from stimulus checks and tax credits in the years following the pandemic, to charging up credit cards and borrowing against their homes to spend more, which caused inflation to largely remain unchecked.
Indeed, government data show that in 2022, total household debt rose by a full trillion dollars as individuals charged up credit cards and used their homes as ATM machines in full force. What this suggested to many observers was that households were less sensitive to higher borrowing costs than some policymakers had predicted, and potentially pointing to a tough road ahead for the fight against inflation.
And so, with markets rallying into the start of 2023 on an expectation that rates would have to fall, but inflationary pressures nevertheless remaining stubbornly high, central bank officials doubled-down on their “higher-for-longer” narrative.
That is, however, until the events over the past few weeks finally gave policymakers the “pain” they were looking for that could finally subdue stubbornly high inflation as the risk of a recession becomes more all the more palpable.
Crisis of Confidence
Now, it’s important to recall that for the past year many economists have been saying that a recession has been in the making and could arrive sooner rather than later. Nevertheless, household spending has been generally solid and the labor market conditions have been robust. And, as we pointed out earlier, a key factor contributing to the resilience of the US economy has been consumer’s ability to borrow money to keep up with spending and inflation.
But now, with fissures forming in the broader banking system, it’s very well possible that an individual’s ability to borrow and spend could come to a rapid end as many banks today aren’t willing to lend even to themselves.
Indeed, the issues facing Silicon Valley Bank, Silvergate, First Republic Bank and others not only led to a run on these banks by their very own depositors, it’s once again leading to a crisis of confidence among the banks themselves, and setting the stage for a broader interbank lending freeze.
And why does the interbank lending system matter to the average individual?
Well, interbank lending is when banks share money with each other for a short time. This approach helps financial institutions to have enough money to do their daily jobs, like giving people their money when they ask for it.
And when banks need to quickly tap into cash, they’ll often share their own reserves with each other through the interbank market. This is like a big meeting where banks talk and decide who will lend money and who will borrow it. Sometimes, banks use a special way to share money called a "repurchase agreement." It's like borrowing money from a friend with a promise to pay them back later with a little extra on the side.
Now, during times of heightened uncertainty, these borrowing agreements between banks seize up as healthier banks hoard liquidity to mitigate their own risks of depositor flight.
And when this happens, central banks step in to help ensure that financial institutions have enough money so that they can meet their daily demands, which makes central banks the, “lender of last resort.”
Now, you’ll likely recall that during the height of the Global Financial Crisis in 2008, the Fed stepped in as the lender of last resort as credit markets froze up following the collapse of Lehman Brothers.
And today, following the failure of Silicon Valley Bank, the Fed stepped in with another set of measures to restore normal functioning to the financial system, including important changes to how the Fed’s discount window works and the introduction of the Bank Term Funding Program (BTFP).
Bank Crisis: Credit Crunch a Silver Lining for Inflation
With all this said, it’s critical to note that while issues in the interbank lending channels likely won’t spark a Great Depression type slowdown, a sharp decline in lending conditions has the potential to lead to a sudden economic deceleration that could put a damper on inflation overall.
And by now, you’re likely asking yourself, “haven’t we been talking about a recession for the past year, what’s different this time?”
Well, as we mentioned earlier, for the past year, the Fed has been trying to “talk” the economy into a recession. Indeed, policymakers have been vocal in their threats to aggressively raise interest rates so long as households keep spending, businesses keep hiring and prices keep moving higher.
And rather than talking the economy into a recession, policymakers have raised rates to a point where it has caused something to finally break in the financial system, which could likely give way to a credit crunch as the likeliest route to the long-awaited economic downturn.
So, how does what’s going on with the banks affect the broader economy and inflation itself?
Well, if banks are less willing to lend to each other, then they’ll likely be less willing to lend to you and your employer. This is what we call a credit crunch. And it’s one reason why, during the Global Financial Crisis, and again this month, that central bankers introduced several measures to return the financial system to regular operations in an effort to avoid what could be a severe economic downturn.
That’s because in response to increased credit risk and heightened uncertainty, banks may become more cautious in their lending practices. This means that as they tighten their credit standards, it makes it more difficult for borrowers, including other banks, to access credit. As a result, as interbank uncertainties persist, overall supply of credit in the economy could begin to dwindle.
And as credit becomes less accessible, businesses and households may cut back on borrowing and spending, leading to a decline in overall economic activity. As this happens, confidence tends to diminish, leading to lower overall spending and investment. And this decline in economic activity can result in lower revenues for businesses, ultimately leading to layoffs and cost-cutting measures. And, when unemployment rises, households have less income to spend, further exacerbating the decline in demand.
So, how does this play into the fight against inflation?
Well, as demand falls, businesses may lower their prices as a way to attract customers and maintain sales volumes. This can contribute to deflation, as the general price level of goods and services in the economy decreases. Indeed, a recession can lead to lower inflation (or outright deflation) through a combination of factors, including lower aggregate demand, tighter credit conditions, and a decline in interbank lending. And when left unchecked, these factors interact in a feedback loop, reinforcing the downward pressure on prices and economic activity.
A Silver Lining Supportive of Risk Assets
So then, from a markets perspective, what does this potentially negative economic outlook mean for risk assets this year? Well, where the markets go from here likely all comes down to the Fed’s rate policies.
That’s because if the Fed has finally caused the pain that it has been seeking for so long, then the recent events in the banking sector likely suggest that the Fed has less of an incentive to continue pushing rates higher from here.
Indeed, the key risk now is that policymakers overtighten, creating a deflationary environment that could be worse than the inflationary one they’ve been fighting for the past year.
That’s why after this week’s meeting, markets are pricing in rate cuts by July, and speculating that the credit crunch likely already underway will be enough to not only curtail inflation, but ultimately lead to an economic downturn that finally forces the Fed to “pivot” as so many market participants have been waiting over the past year.
And while this perspective might make getting back into the markets attractive at this point in time, there are several reasons for investors to remain cautious in the current environment.
First, it’s not yet clear yet whether we’ve seen the end of stresses in the global financial system. While the factors contributing to Silicon Valley Bank can be attributed to poor risk management, a crisis of confidence ultimately sparked its demise and triggered troubles for other flagging banks.
Second, while it’s possible that a credit crunch could be the answer to the Fed’s inflation problem, only time will tell whether the inflation fight is largely over. Indeed, policymakers are walking a fine line between preserving systemic stability, and taming inflationary pressures. That’s why incoming data over the next couple of months will be crucial to determining how much leeway policymakers have to cut rates as growth slows.
Finally, even if inflationary pressures finally appear to be under control, there’s a risk that stocks likely won’t move higher in a straight line. Indeed, in the months following the collapse of Lehman Brothers and the introduction of government rescue programs, the markets continued to sell off sharply before finding their footing and setting the stage for a broad bull market rally.
That’s why as you’re looking over the current environment and considering your investment decisions, your most prudent choice likely will be to avoid market timing and stick with your long-term disciplined investment strategy.
That’s because accurately predicting the direction of the market is inherently challenging due to the multitude of factors that influence market movements. These factors can include macroeconomic indicators, policy changes, corporate earnings, geopolitical events, and investor sentiment. And the complex interplay of these factors makes it nearly impossible for investors to consistently predict the optimal entry and exit points in the market.
What’s more, market timing often relies on emotional decision-making, which can lead to irrational behavior. That’s because when market volatility is high, fear and greed could drive you to make impulsive decisions, such as selling assets during sharp declines or buying during periods of rapid appreciation. Such decisions are often driven by short-term market fluctuations rather than a long-term investment strategy, which can result in suboptimal outcomes, especially if the risks we mentioned earlier come to the foreground.
Ultimately, it’s essential to remember that some of the best days in the market have occurred during periods of high volatility, and missing out on these opportunities can have a detrimental impact on long-term investment performance.
That’s why focusing on the most crucial aspects of investing, such as proper asset allocation, portfolio diversification, and long-term investment planning can help mitigate unnecessary financial risks and improve your chances of mastering your path to financial independence.
Don’t Hold Your Breath: Rates Aren’t Coming Down Anytime Soon
If you've been hoping for interest rates to fall this year, I've got some bad news for you: borrowing costs will likely only go higher from here.
At least, that's what we've been hearing from various Fed officials over the past couple of weeks. More specifically, these individuals have been telling us that the central bank should continue raising rates into the foreseeable future, and the fact is that incoming data supports their case for future rate hikes.
To this point, inflation data for January showed that prices accelerated at a faster-than-expected rate, rising 0.5% on a month-over-month basis. What's more, the data also show that US labor market conditions remained robust in January, as employers added over 500,000 jobs to their payrolls, besting economist expectations of a slowdown.
And if that wasn't enough to dash the market's hopes of lower interest rates this year, government data just recently showed that households spent at a faster-than-expected rate of 6.4% last month compared to a forecast of 4.5% for January.
If we're in a recession at this moment, then this is possibly one of the strongest economic environments we've experienced in a while heading into the start of an economic downturn. This perspective is relevant because history tells us is that the Fed tends to pause interest rate hikes as the data begins to turn to the downside. And so far, while there is some evidence of slowing economic activity, the data does not yet make a solid case to prevent policymakers from raising rates higher from here.
Hope for a Fed Pivot (Continued)
Now, if you've been following along with the markets, you likely know that some investors anticipated interest rates to rise only modestly this year. Thereafter, the hope was that the Fed would pause its rate hike cycle and eventually begin cutting rates by year-end as the expected recession unfolded.
This market narrative was a key factor driving risk asset outperformance in the first few weeks of this year. Indeed, US stocks in January had one of their best starts to the year in a long time on hopes that the Fed would eventually pivot away from aggressive rate policies and pave the way for a market rally this year.
For example, at the start of the year, markets were pricing in 0.25% rate increases by the FOMC in February and March, followed by a pause in rate hikes and then an eventual rate cut by year-end.
Nevertheless, as January came to a close and key economic data began rolling in for the month, it became clear that economic conditions do not yet warrant rate cuts this year.
Indeed, the incoming data suggests that a severe economic downturn hasn't presented itself yet if we look at the health of the household as a key barometer of activity. To be sure, this activity is critical to note because nearly two-thirds of gross domestic product (GDP) is made up of household spending alone!
From this perspective, a case can (and in some instances already has) be made that policymakers will need to continue raising rates until something breaks in the economy or financial system that would eventually warrant a rate cut.
So, then, what are some conditions that likely need to be present for policy rates, and hence borrowing costs, to fall later this year? For now, developments in the housing and labor markets likely will be critical indicators for confirmation that economic conditions have slowed to levels that support lower inflation over the near-term, which could give policymakers the cover they need to take their foot off the policy brakes.
Housing Market Developments
And why is housing a critical factor in the Fed's rate calculus?
Well, that's because what happens in the housing market is critical to measures of inflation. That's because housing costs, as it relates to its contribution to overall inflation, make up a sizable portion of the consumer price inflation (CPI) basket. Indeed, over the past couple of years, owner's equivalent rent, or the cost of housing, has skyrocketed from an average rate of around 3% from 2010 to 2020 to nearly 8% in January of this year.
What this means is that it's becoming more expensive for households to pay to keep a roof over their heads as the cost of servicing a mortgage has risen and average rents nationally continue to climb. And while activity in the housing market has slowed over the past year, incoming data show that conditions have actually stabilized.
For example, while inventories of new and existing homes went up mid-last year as buying activity slowed as the Fed began raising interest rates, the number of homes available for sale presently is falling back to levels we last saw just a year ago. What's more, homebuilders' sentiment improved in January at a better-than-expected rate as homebuying activity remained resilient in the face of rising borrowing costs.
Resilient Labor Market
And shouldn't have rising borrowing costs killed consumers' appetite for homeownership?
Well, one of the reasons why homebuyers have remained resilient is because wages continue to rise and hiring in many parts of the labor market remains robust. Data released in early February showed that employers added another 500,000 jobs in January, nearly double the rate that many economists had predicted for the month.
And with interest rates rising and the economic outlook seemingly so uncertain, why would we continue to see more jobs added from one month to the next? Or, put a different way, why is the labor market still so strong even when other indicators have suggested for months that the US economy could be headed for a recession?
While there is a myriad of explanations for this uncertainty, the fact is that there are many demographic shifts that have taken place over the years that have led to a stubbornly strong labor market today.
For example, even in the pre-pandemic era, employers had been looking for qualified workers and had difficulty filling open positions. This reality is exhibited in the upward trend in JOLTS time series data. And given that employers were once challenged to bring on new workers, they're likely less willing to let go of these same workers even as slowing economic conditions put pressure on margins.
And recently, with prices increasing and labor market shortages abounding, business owners have used inflation as a cover to raise the prices of their goods and services, pay higher wages, and pass those costs on to consumers. Indeed, in January, average hourly earnings grew 4.4%, a slowdown from nearly 6% in early 2022 but remains well above the less than 3% average over the past decade.
What this means is that households increasingly have more money to spend as employers pay new workers higher wages or offer outsized cost of living adjustments to existing employees as a means to keep them on board.
What it Means for the Markets
The conditions that would have justified just two more rate hikes this year and that led to a solid risk-asset rally in January are likely no longer present. To be sure, as it stands today, market participants are, in fact, pricing in three more rate hikes this year. What this means is that we're likely to see heightened market volatility in the months ahead as investors look for a new narrative to support the nascent cyclical bull market rally for the year.
So, what factors will market participants likely be watching to evaluate market direction looking out into the rest of the year? Well, as recent data have demonstrated, the health of the consumer will likely be central to the market narrative this year. And directional data points relevant to these measures include resilience in the labor and housing markets.
The hope is that as activity in these sectors of the economy begins to weaken, so will inflation. And as inflation data (which tends to lag as an indicator of price momentum), confirms what the housing and labor market tells us, investors likely will have the confidence they need to move ahead of policymakers once again and drive risk-asset prices higher.
What it Means for Your Finances
Until then, we continue advocating for an investment strategy that is consistent with your long-term risk tolerance, goals, objectives, and, most importantly, your financial plan. Indeed, now may not be the time to take on additional investment risk. In fact, given the strong rally this year and renewed macroeconomic uncertainties, we continue advocating for a disciplined cash management plan, especially for those investors who are currently drawing down on their savings to fund their post-employment living expenses.
Outside of investing, it's vital to note that financial markets are pricing in rates to go up another 0.75% this year. What's more, policymakers have indicated the interest rates likely will need to stay higher for longer. Therefore, if you need to borrow to make a purchase, consider your options as the potential to refinance at lower rates likely may not come for more than a year or more from now.
On the flip side, higher interest rates have finally made it beneficial for individuals to hold cash. While the purchasing power of cash continues to be eroded on an inflation-adjusted basis, you now have more options in today's environment to put your money to work in a relatively risk-free manner.
For instance, many financial institutions now offer savings and Certificate of Deposit (CD) accounts that pay interest of over 4.5%. This reality is especially salient given that if we are headed for a recession in the second half of the year, then preparing an adequate cash buffer to weather an economic downturn is essential now more than ever.
Make no mistake, borrowing costs are only likely to go up from here. As a result, we're likely to see higher levels of market volatility and economic uncertainty in the months ahead. That's why even after a solid start to the year in the markets, it's essential to avoid financial complacency. Indeed, taking a few steps right now to position your finances properly likely will put you one step closer to mastering your journey to financial independence.
Markets in 2023: It's All About Inflation
To say that 2022 was a disappointing year for investors is an understatement. US stocks gave up more gains to close the year than they have since the height of the Global Financial Crisis. And even bonds, which tend to move higher when stocks fall, saw their worst declines in decades in 2022. And while some investors sought out cash as a haven of sorts, double-digit inflation and a rising cost of living ate into the purchasing power of most savers. Ultimately, investors had no safe place to hide from this year's economic and market carnage, and it's arguably all the Fed's fault.
Understandably, after this year's market volatility, many investors are ready to throw in the towel and move to the sidelines as there appears to be no end to the ongoing economic and market uncertainty. Even so, as we look ahead to the coming year, there are some early signs that we may finally receive the long-awaited relief rally sought by so many investors. And that's why getting out of the markets now could mean potentially missing out on the start of the next bull market rally. To get to that rally, however, we’ll likely need to move through more uncomfortable periods of market ups and downs.
While it feels like the floor is coming out from under the markets, the unwinding that we're seeing across the financial system today is arguably not primarily driven by bubbles bursting as they did in 2000 or 2008. Instead, what's different about this selloff is that policymakers, namely the Federal Reserve (Fed) and central banks globally, are purposefully engineering an economic and market decline by raising interest rates in a bid to combat out-of-control inflation.
What this means for many investors out there is that, once policymakers are sufficiently convinced that inflationary pressures are under control, their next likely move could be a pause in interest rate hikes before lowering them once again. Now, this outcome is essential for financial markets because, typically, in a bear market, risk assets tend to find their footing and rally higher when economic conditions are prime (like when inflation is falling and the economy is stalling) for the Fed to cut interest rates.
And as you'll likely recall, this expectation led to fits-and-starts in 2022 as many market participants prematurely held out hopes for a "Fed Pivot."
So, if the Fed is engineering an economic slowdown that led to the recent market selloff, what needs to happen in the coming months before the central bank finally starts cutting interest rates again and giving the markets a chance to rally higher?
Well, policymakers likely will need to see three economic conditions play out before changing their approach, including:
- a drop off in consumer spending,
- a reset of inflation expectations, and
- a persistent declines in services inflation.
As these conditions are met, we likely will see a bottom formation in the current market selloff, which, holding all else equal, paves the way for a higher market close in the year ahead. As we move towards these conditions, we will likely face increased market and economic volatility in the first half of 2023.
Household Spending Needs to Slow
Now, one question you may be asking yourself is, "why would the Fed care about curbing household spending when its key concern is inflation?" Well, if you think back to your college Economics 101 courses, then you'll likely recall that high inflation tends to happen when there are either too few goods to purchase (or a supply side inflation) or too much money chasing too few goods (demand side inflation).
And following the pandemic in 2020, we did experience the effects of supply-side inflation as global supply chains came to a screeching halt, and prices for some goods on store shelves moved higher. But you'll also recall that the Federal Reserve and US government as a whole injected trillions of dollars into the financial system and economy to stave off what could have been an economic downturn worse than the Great Depression.
Now, while money printing helped to stave off what could have been a devastating recession, all of that extra money, combined with global supply chain bottlenecks, ultimately led to more money chasing too few goods. Adding insult to injury, as supply chain issues were resolved, households continued to spend at historically high rates while businesses further raised prices on goods and services sold.
One reason for this is that the pandemic led millions of individuals to retire early or quit the labor force altogether. And a lack of qualified workers in several key economic sectors ultimately led employers to raise wages to entice individuals to come back to work. So, combine extra cash available from higher savings (stimulus checks) coupled with higher incomes, and now you have a recipe for higher household spending.
Now, policymakers can’t directly determine how you or I spend our money. Still, they can influence our spending decisions by introducing economic uncertainties that prompt questions like, "should I save more money because I could lose my job" or by ultimately making it more expensive to purchase big-ticket items like a home or automobile. This point, arguably, was likely one of the reasons why Fed Chair Jay Powell alluded to the central bank's need to inflict "economic pain" during his comments at the Jackson Hole Symposium back in August.
So far, the economic data suggest that one indicator of consumer spending, retail sales, remains robust. Even broader gauges of spending, like the government's measure of personal consumption expenditures, show that while slowing recently, spending continues to grow at a steady clip with little sign of abating.
Now, with all that said, there is hope that the Fed's policies are beginning to have an effect. That's because the data show that households, after spending through pandemic-era stimulus cash, are seeing their personal savings rates fall to their lowest levels in recent history. This low level of savings suggests that some individuals are finally achieving the limits of their spending ability.
Another sign that households are becoming financially tapped out is what's happening in the lending market. For example, outstanding revolving debt balances, including credit cards, are now back to their highest levels in history. In fact, in less than two years following the pandemic, consumers charged up nearly $200 billion worth of spending to their credit cards and other revolving lines of credit. To put this figure into perspective, it took households seven and a half years to charge up the same amount of money to their credit cards in the years following the Great Recession!
Taken together, what the data likely means is that while households are earning more today, their savings are being depleted, leading some individuals to use credit cards to pay for non-essentials as prices rise and, in some cases, to spend beyond their means. And as the Fed continues to raise rates, higher interest charges will likely make it more difficult for individuals to live off borrowed money, potentially putting a damper on economic consumption in the months ahead.
Expectations need to Fall
Another factor that Fed officials closely watch is expectations. That's because your and my expectation of where we think inflation is headed often shapes how inflation plays out in the months and years ahead. Indeed, what we believe about inflation often turns it into a self-fulfilling prophecy.
For example, suppose you expect the costs of maintaining your household to rise with no end in sight. In that case, you and your coworkers will demand your employer to give you a raise to cover your cost of living adjustment, or you'll likely seek a new job that pays you more to cover your rising expenses.
So, how do we measure this sentiment? Well, several outfits conduct their own surveys to gauge household inflation expectations. And one of the most prominent surveys comes to us from the University of Michigan, whose latest reading shows that household inflation expectations remain among their highest levels in decades.
Similarly, if businesses expect costs to continue rising in the years ahead, they'll likely raise their prices now to compensate their workers and pad their margins. This expectation of higher inflation among business leaders is evident in the Richmond Fed's recent CFO survey.
For example, in its latest print, business leaders indicated that they expect unit costs to rise 9.2% in 2022 and a further 6.7% in 2023. Adding insult to injury, executives surveyed also predict wage growth to rise another 6.9% in 2023!
Now, if we measure inflation as the realized price consumers expect pay for goods or services, it's hard not to see how these rising expectations flow through to inflation. That's why policymakers are keen to make economic conditions so unbearable for individuals and businesses alike, that workers remain grateful for having a job during an economic downturn and business leaders are willing to put their goods and services on sale to entice the next marginal buyer so they can, at the very least, cover their operating expenses.
Inflation Trends Need to Confirm
Finally, in terms of conditions that policymakers likely will be watching before changing their policy stance in the coming months is actual incoming inflation data. These data include the headline CPI (consumer price index) and the Fed's preferred measure of inflation, PCE (personal consumption expenditures price index).
Now, the trouble with using price indices as inputs to direct policy is that they tend to lag behind the mechanisms that drive inflation in the first place. That's why measures of inflation, like the consumer price index, are best viewed as confirmation that policies have taken effect rather than leading indicators of future household or business activity.
So, what's the data telling us? Well, incoming data suggest that Fed policies are having their desired effects on inflation to a certain extent. Indeed, recent data shows that headline inflation in November fell to 7.1% from its peak of 9.0% earlier in the year. To put this number into context, however, the current inflation reading is still five percentage points above average and remains well outside the Fed's 2% inflation target. This current trend means that the Fed still has work to do to get inflation under control.
And while we've seen food and energy prices begin to ebb to a certain degree, one of the most significant components of inflation is shelter prices, which remain stubbornly high. In fact, shelter accounts for a full third of CPI. But, there's hope among some policymakers that the Fed's restrictive policies could take the air out of the overheated housing market and bring overall inflation back down to ground.
Indeed, recent data show that home prices are now falling but remain elevated from where they were a year ago. Even so, lender Freddie Mac projects that home price growth will decline on a year-over-year basis next year, and many other economists predict a decline of between 3-4% by year end 2023. Such price declines could be a welcome development for price inflation overall, but that likely won't be enough to curb the current effects of inflation.
Another critical factor influencing current price levels is what's happening in services inflation. What is services inflation, you ask? Services inflation includes the prices we pay for housing (rent), health care, eating out, transportation, and online subscriptions. While headline CPI has fallen from record levels this year, services inflation in November, on the other hand, marked one of its fastest periods of growth in over three decades.
And why is this important? Because as a share of overall consumption, households today spend more on services over goods than they had over forty years ago. So, while falling headline inflation likely will be perceived by some market participants as a hopeful sign that the Fed could eventually begin easing back on its rate hike policy, what happens with housing and services inflation likely will play a more prominent role in Fed policy decision making in the months ahead.
It's All About Inflation in 2023
At this point you may be wondering, "what does all this talk about inflation have to do with my financial independence savings?" Well, the simple answer is that the Fed cares about inflation, and the markets care about what the Fed will do next. Until the Fed stops raising interest rates, investors will likely be challenged to find a direction in this uncertain market, especially as an economic and earnings recession looms large on the horizon. That's why, for the markets, it's all about inflation in 2023.
To be sure, how and when the Fed ultimately decides to exit this latest rate hike cycle is anyone's guess. However, there are some guideposts that investors are watching to help provide some indication of the market's next potential move. And these include household spending, price expectations, and headline inflation reports.
So far, none of these indicators have fallen to levels that would prompt policymakers to shift gears, which is why market hopes of a "Fed Pivot" in 2022 have fallen flat. This means that market volatility will likely remain elevated for the foreseeable future. Indeed, for the first few months of the year, we expect market direction to be biased to the downside until we see evidence that inflation has sharply decelerated or a shock event (like a sudden economic downturn) takes the wind out of inflation's sails.
Until then, our guidance remains unchanged from where it has been in 2022: stay the course. But as we head into another period of heightened market volatility, here are three things you can do to ensure that your goals stay on the right track.
First, keep enough cash on hand to help you sleep well at night when the markets go south. This approach could help you avoid selling securities at inopportune times in the markets.
Second, stay committed to your disciplined investment strategy and avoid trying to time your way into and out of the markets. History has shown that the best days in the markets typically happen towards the end of a bear market selloff and missing out on those days could cost you.
Finally, and most importantly, stay focused on the long-term purpose of your money and make grounded financial decisions. We're more prone to make emotionally based decisions when the future appears uncertain.
When it comes down to it, there's little we can do to control inflation, the Fed's next move, or how the markets will respond. Ultimately, you can rest assured that your financial plan exists to help you navigate your path to financial independence no matter what's going on in the world around you.
Don't Be Fooled by the Santa Claus Rally
Christmas is just around the corner, and if you're like many investors, then you likely have a year-end rally on your wish list. If this is you, then you're probably in luck because history has shown that a so-called Santa Claus rally could be in the making in the weeks ahead.
Make no mistake, after this year's bout of market volatility, many investors are looking for hopeful signs that their savings and retirement balances will once again be on the rise heading into the new year. And history has shown that over the past few decades that Santa, more often than not, has brought cheer to the good little boys and girls on Wall Street in the final few days of the year.
How do we know this?
Well, looking at data going back over forty years, our work suggests that the S&P 500 Index has gained an average of 1.0% in the six days following the Christmas holiday and into the first few days of the new year. And what's more, in the years where the markets have had negative year-to-date performance, like we're experiencing this year, the markets tend to rally an average of 1.5% in just a few short days.
So, the question on many investors' minds now is, "is the Santa Claus rally possible, and will it pave the way for a broader rally next year?"
The short answer to this question is yes… but...
History has indeed shown that positive annual market gains have followed a sustained Santa Claus rally in down years. However, 2022 has not been your typical year by any stretch of the imagination. And while a bull market could be in the making for the coming year, several factors suggest that we're likely to experience bouts of heightened volatility before markets finally transition to a rally.
What's Supporting Sentiment Now?
The good news is that market sentiment appears to be showing signs of improvements at the margins, which has been evident in higher prices among many parts of the US and global equity markets over the past six weeks.
Amidst all these market moves, what's essential to understand is that the Federal Reserve has been a critical driver of market sentiment this year. In its bid to quell double-digit inflation, the central bank committed to an aggressive policy response, raising rates six times since March and to their highest level since 2007. Markets responded to this development by selling off sharply in anticipation of an economic and earnings recession.
Overall, however, the economic slowdown that had been predicted didn't quite play out as many market watchers had anticipated. And by many measures, US firms have adapted to rising input prices and slowing demand, ultimately allowing corporations to avoid the deep earnings recession that had been predicted just months ago.
What's more, heading into this year, many corporations demonstrated discipline with their cash reserves, while households have generally felt confident enough to spend freely despite signs of growing stress in the overall economy.
As a result, many investors have taken these signs of economic resilience as an indication that maybe financial conditions aren't as bad as what was priced-in earlier this year.
And this point is essential because some investors believe that if the economy is in a better position to weather higher interest rates, then when the Fed eventually stops raising rates, the economy, corporate earnings, and the markets could bounce back sooner than expected.
Things Likely Will Get Worse Before They Get Better
While there's no doubt that growth has been more resilient than expected, incoming data for the fourth quarter suggest that the economy could be headed for another leg lower.
And this trend is likely to be exacerbated by the fact that it takes time for the effects of higher interest rates to make their way through the economy at large.
For example, even if the Fed announced no further rate hikes tomorrow, the US economy likely would continue to slow for months to come.
And from this perspective, corporate earnings will likely face headwinds in the coming quarters as data reflect depleted consumer purchasing power, evident in declining household savings and rising credit card utilization. In anticipation of this slowdown, firms are increasingly reporting plans to let go of workers, which could set in motion a negative feedback loop for the economy.
Rising interest rates have already impacted consumers, evident in declining housing affordability and purchases of big-ticket items like automobiles. And while many corporations are holding onto high levels of cash on their balance sheets, those that actively borrow in the credit markets to fund operations likely will see more of their operating cash flows diverted to debt service costs as interest rates remain elevated.
Barring other factors, we could finally see the strong labor market turn a corner as layoffs and hiring freezes become more widespread throughout the economy.
This expectation of weaker growth is now baked into consensus expectations for 2023, with many economists once again anticipating an economic contraction in the first and second quarters of 2023.
Putting it Into Perspective
Given this outlook for a weakening economic environment, it's likely that market sentiment could decline in the months ahead. Indeed, the critical market narrative supporting market optimism among many investors this year has been "the Fed Pivot," or buying in anticipation that policymakers will eventually stop raising interest rates.
Even so, Fed officials have been actively voicing their insistence since Powell's pain remarks in August that little evidence suggests that the Fed is done raising rates anytime soon. And while we've seen a market rally in November, it's entirely possible that what we're seeing now, and likely to see through year-end, is simply a bear market rally.
Indeed, in 2008, large-cap stocks rallied 27% between November lows and early January 2009 before markets capitulated, eventually marking the bear market low of March 9, 2009.
Overall, while some indicators suggest that a market bottom could be in the making now, like the recent bull-bear spread trend in investor sentiment, or put call ratios, market participants today are navigating largely uncharted territory.
Don't Be Fooled by the Santa Claus Rally
Putting it all into perspective, the Santa Claus rally would be a welcome development after this year's market disappointment. Even so, one would be wise to approach any year-end rally with caution.
To be sure, uncertainties regarding the current economic outlook coupled with looming geopolitical uncertainties in Ukraine and China suggest that we may be looking at more volatility in the first half of 2023.
And while economic data is currently in decline today, policymakers likely will wait until they see "pain" in labor market data and declining inflation expectations before indicating that they could change their stance on monetary policy.
This holiday season, don't be fooled by a Santa Claus rally. While it may be tempting to jump on board the year-end rally should it arrive, conditions are prime for disappointment as we likely headed for a fresh bout of market volatility in the weeks ahead.
That's why a disciplined risk management approach and an eye for opportunity likely are sensible approaches as we look ahead to the start of 2023. Indeed, we recommend avoiding taking excess risk in the markets, and using recent rallies to rebalance to target asset allocation levels.
We'd also suggest keeping higher cash levels on hand to weather prolonged market selloffs and avoid selling securities at inopportune times as a way to preserve your path to financial independence.
Nobody Knows What's Going On
If you follow financial media with the slightest interest, then you’ve likely heard of Jim Cramer.
In case you don’t know him, Cramer is a staple on CNBC and known for making bold calls on individual stocks and the markets.
Lately, however, Cramer has become internet famous for getting the markets wrong.
And that’s because, unfortunately for Cramer, many of his “buy, buy, buys” from months ago have proven to be complete disappointments. His most notable public flop was his seeming infatuation with the company Meta (Facebook), whose stock is now down well over half its value this year.
Now, his bad calls have become so persistent that Cramer has become an example of how not to invest your money. And this has led at least one fund manager to announce its plans to launch an inverse-Cramer exchange-traded fund (ETF) to raise money that would bet against the pundit’s market calls.
Make no mistake, while Cramer is most notable for his unfortunate calls, there are other market prognosticators out there, including individuals like Cathie Wood and Chamath Palihapitiya, who have had highly visible bad calls and their own falls from grace with their investors.
The point here is not to poke fun at another financial professional for their folly but rather to point out that sometimes, no matter how convicted one may be about a view, the economy or markets will behave in a way that we don’t expect.
Take the current mainstream market view, for example.
Coming into October, an imminent economic, earnings, and market crash was inevitable, according to some views. Today, that doesn’t seem to be the case, as economic and market conditions are faring much better than some pundits had anticipated.
Now, it’s understandable why some individuals were calling for a complete financial collapse. A month ago, interest rates were pushing to levels we hadn’t seen in over a decade, putting strain on some parts of the global markets. This development led some individuals to believe that the same systemic risks present during the Global Financial Crisis well over a decade ago were now coming back.
Adding to the worry coming into this month’s corporate earnings season were expectations among many market analysts that higher operating costs and economic woes likely would eat into the bottom lines of firms across many sectors across the economy, leading to a disappointing reporting period.
And if systemic issues and earnings disappointments weren’t enough to add to the individual investor’s reasons to worry, well, October was supposed to be a month where market participants would finally throw their hands up in their air, and usher in a market selloff to the degree of which we likely wouldn’t have seen since the height of the Great Recession.
But none of these things happened.
Rather than catastrophe, incoming reports reflected a resilient economy, better-than-expected earnings, and strong moves higher in some parts of the markets.
The simple truth is that nobody knows what’s going on.
What Went Wrong?
So, what do we know after seemingly looking into the abyss a month ago? Well, we know that the U.S. economy was in a much more solid position in the third quarter after two quarterly declines at the start of the year. We know that firms can still pass costs along to consumers without complete demand destruction. And we know that the market’s direction is not entirely dependent on one broad market narrative, like the “Fed Pivot” we’ve heard about recently.
For example, when the U.S. government released a first-look at U.S. growth last week, it showed that the economy advanced at a better-than-expected 2.6% quarterly annualized rate in the third quarter. While signs of the housing slowdown were evident in the data, household spending was resilient despite consumer confidence being at its lowest levels in 40 years.
On the earnings front, the much-anticipated earnings recession failed to materialize. Over two-thirds of S&P 500 companies that have reported so far have beat expectations. And while some major tech companies reported disappointing earnings that led to double-digit declines in their stock prices last week, 81% of reported tech companies had beaten expectations, according to S&P data.
And how about that bear market selloff that some investors were expecting? Well, investor confidence, as measured by the American Association of Individual Investors, is at its lowest since late 2008. But, following last week’s earnings release, the Dow Jones Industrial Average is on track for one of its most robust monthly gains in decades, with dozens of stocks in the S&P 500 index pushing to new highs following last week’s earnings announcement.
No One Knows What’s Going On
Now, if you acted on the mainstream market view of doom and gloom coming into October, you likely would have faced some major financial disappointments this month.
The fact is that predicting the future is hard work.
While many financial professionals borrow tools from the hard sciences to assign probabilistic outcomes to future events, making directional calls on the economy and markets is challenging in the current environment.
Make no mistake, many well-intentioned professionals rely on complex data to make useful predictions on the future of the economy and markets. Yet, in many ways, historical data is a less helpful analog for what’s going on in today’s environment.
Using a reference from the data analytics approach, we have entered a period with a structural break in the data. Or, to put it differently, the historical data used by some today to forecast the economy and markets is less valuable than it has been in the past.
For example, we’ve gone from a multidecade decline in rates and inflation to rising borrowing costs and higher-priced goods and services. Structurally, the U.S.’s geopolitical influence globally is coming under considerable pressure, and its key source of influence (a dollar-based global financial system) is, in some ways fraying at the edges.
Add in a digitized economy and how it has changed how households work and how they buy goods and spend their money, and it’s not too difficult to see that many of the past predictive regimes are now in flux and less informative to diving the future.
That’s why trying to apply hard-and-fast historic rules of thumb to current market conditions can be a setup for financial disappointment or, in the case of market prognosticators like Jim Cramer, a source of awkwardness.
Where to from Here?
Few individuals know where the economy and markets are headed next week, next month, or next year.
And, the lessons learned from individuals like Cramer or others out there is that holding firm to a past conviction in a rapidly evolving market and economic environment can lead to financial mistakes.
So, if you’re the individual who gets caught up in the moment-to-moment moves in the news cycle to manage your finances from one moment to the next, then you’re likely setting yourself up for failure.
What you may want to consider is having strong opinions loosely held. Or as economist John Maynard Keynes put it, “when the facts change, I change my mind…”
Either way, what’s essential to gaining peace of mind in times like these has less to do with figuring out the markets and more to do with having a solid long-term financial plan from which to manage your money so that you can look past the near-term headline noise.
Make no mistake, there’s still strong evidence to suggest that we’re likely to see slower economic growth, earnings disappointments, and more market volatility in the coming months.
The fact is that we don’t know, nor can we control, how and when these events might take place. That’s why rather than basing your financial decisions on what you think might happen next month or next year, stay focused on your long-term financial plan.
Indeed, focusing on things you can control in your financial plan, like spending and savings decisions, and staying committed to your disciplined investment process might help you secure your path to financial independence in an environment where nobody knows what’s going on.
Hold Tight in this Financial Meltdown
US equity markets have officially erased their summer gains. The Dow Jones Industrial Average is back in bear market territory, and the S&P 500 is on pace for its worst year-to-date start in recent history. Adding insult to injury, rising US Treasury yields have pushed borrowing costs to seemingly unsustainable levels as mortgage rates in some markets are now above 7% from around 3% just months ago.
It feels like the financial system is about to break.
The fact is that we’ve been here before. In many ways, today’s financial environment is similar to the one that played out during the height of the Global Financial Crisis in 2008.
And I’m taken back to the early years of my career when our Chief Investment Officer held weekly calls for our advisors to help them navigate the market volatility.
If you’ll recall, at the time, Countrywide was handed over to Bank of America months earlier, while Lehman Brothers and Washington Mutual had just gone under. Money markets had just “broken the buck”, AIG was getting bailed out, and Wachovia was pushed into the arms of its competitor for pennies on the dollar.
Fourteen years ago this week, the financial system was melting down in front of my very own eyes.
Understandably, our clients (and team of advisors), were panicking. The floor was falling out from under many individuals’ retirement plans and overall financial well-being. At the time, market participants and households alike were looking for simple answers to a challenging situation.
Now, our weekly calls involved hundreds of investment professionals, and many of them felt like they needed to do something. Some advisors wanted to implement exotic derivative strategies to stem the losses in client portfolios. Others suggested buying specific stocks or sectors amidst the selloff. And other advisors were doing everything they could to stop themselves from simply getting out of the markets altogether.
So, what was the advice from our Chief Investment Officer?
Hold tight.
The advice offered then still holds merit today, and here’s why.
Why You Should Hold Tight
As the financial system was coming unglued in fall of 2008, few individuals knew what the path forward would look like. Investors were desperately looking for a catalyst to drive financial assets higher, but a positive market narrative was nowhere to be found.
The old rules of how the financial system should function in many ways no longer applied during that time.
Even so, policymakers stepped in with creative approaches to undergird the financial system. As you’ll recall, in October 2008, the US government introduced the Troubled Asset Relief Program (TARP) to prevent other financial institutions from failing.
In November of the same year, the Federal Reserve launched a historic quantitative easing program aimed at buying up bad debt and restoring confidence in the financial system by showing that policymakers had “tools in the toolbox” to address the market dysfunction. The central bank also introduced a number of measures to support global central banks that had been experiencing stresses in international markets.
By March 9, 2009, market participants were finally convinced that the right set of tools were in place to avoid any further catastrophic collapse in the financial system, and risk assets susbequently rallied.
In the year that followed the March 2009 lows, the S&P 500 index would nearly double in value and then rise by around 600% through December of last year.
Now, there are some individuals whose investment experience was far worse than the broader market. It was those individuals who got out of the markets in January 2009, waiting on the sidelines for an “all-clear” signal before putting their money back to work.
Keep Moving Forward
The point here is that when it seems like the world is crumbling around you and the path forward appears ambiguous, the best course of action may be to simply hold tight and keep moving forward.
Indeed, three fundamental principles apply here when it comes to managing your finances in times of uncertainty:
- Focus on what you can control
- Try not to get caught up in the emotions of the day, and;
- Stay in the present moment
What You Should Focus On
To the first point, there is only so much that we can control when it comes to managing our lives or our money. During times like today, I’m often reminded of an illustration from Carl Richards over at the Behavior Gap. It’s a Venn Diagram with two circles.
In the left circle are the “things that matter.” And in the right circle are the “things you can control.”
When you bring the things that matter, and things you can control together, what you find is that there are only a few items in life that you should be focused on when the economy or markets are in decline.
These areas should include reminding yourself of the long-term financial purpose that you’ve defined for your wealth, and the plan you’ve put in place to address times like these when the markets go south.
These actions could include reevaluating your investment strategy to ensure that your holdings are aligned with your long-term goals. It can also mean ensuring that you have a cash management strategy in place to avoid having to sell investments at an inopportune time.
Stay Objective
The next component to holding steady in times of uncertainty is to remain objective and avoid getting caught up in emotions when the markets are gyrating up and down.
Now, it’s been said that watching the stock market every day is like watching someone play with a yo-yo while riding up a moving escalator.
You’re likely to feel a high degree of stress if you focus on the yo-yo rather than where the escalator is headed.
If you find yourself worried about the markets and glued to financial media desperately seeking out answers, now may be a good time to turn off the TV and go for a walk.
There’s no better time than the present to remind yourself that over the long-term, financial markets have historically rallied after periods of extreme volatility. Remember, the role of financial media often is to sell emotion and rarely to provide any meaningful advice.
And if you find yourself stressed and still looking for answers, now may also be a great time to reach out to your trusted advisor to get an objective opinion on your options.
Stay in the Present
Finally, it’s vital to stay present in uncertain times like these. John Kabat-Zinn had a saying that “wherever you go, there you are.” What this means is that the one constant we have throughout our experience with money (or life in general) is how we deal with the present moment.
There’s nothing we can do about the past and very little we can do about future events outside of our control.
That’s why during these times of economic and market uncertainty, it’s essential to focus on what you need to do right now. Not sure what to do? Then go back to your financial plan and remind yourself what you need to do now to make your goals a reality.
Don’t have a plan?
Well, there’s no better time than the present moment to put one together. Either way, avoiding rumination on past or upcoming financial decisions begins with staying focused on what needs to be done right now in the present.
Where to from Here?
Make no mistake, the events unfolding in financial markets today feel ominously similar to the events that took place fourteen years ago this week. Equity markets at home and abroad seem to feel like they’re in some sort of freefall. The US dollar’s strength is squeezing international financial markets while bond yields are heading relentlessly higher and stocks are moving lower.
And the key reason that markets are behaving the way they are today is mainly due to uncertainty around what appears to be a self-inflicted wound from policymakers: a desire to inflict pain in order to tame inflation expectations.
It’s scary out there, and it feels like things can only get much worse.
But here’s what’s key: we’re going to get through this market dislocation just like we did during the Global Financial Crisis, Savings and Loan Crisis, Energy Crisis of the ’70s, and so many other crises from the past.
The solution to today’s high government debt and experiment in money printing likely will require a solution that hasn’t been presented yet.
For now, policymakers appear to be out of tools that address historically high inflation while avoiding a crash in the economy and financial markets.
What history has shown, however, is that when it seems like it can’t get any worse and there’s seemingly no way out, a solution eventually finds a way, allowing risk assets to breathe a sigh of relief and rally higher.
Until then, hold tight.
Eight Minutes that Derailed the Bull Market
By some measures, Fed Chair Jerome Powell derailed the fledgling bull market rally in U.S. and global risk assets last Friday. In eight short minutes, the central bank governor drove home the point that the Federal Reserve would do everything within its power to halt inflation, including bringing economic “pain” to U.S. households and businesses alike.
For the markets, it was a halting realization given the fact that the recent market rally had been predicated, at least in part, on the Fed pausing rate hikes and giving the economy some breathing room as various data points have shown that a U.S. recession is looming on the horizon.
But not anymore.
On Friday, Jay Powell briefly laid out a case explaining why it’s essential for the Fed to focus first on inflation, not the economy or the markets. To that end, he ended his speech with a determination to bring inflation back to normal by stating that:
“We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”
- Federal Reserve Chairman Jerome Powell, Jackson Hole, August 26, 2022
The Narrative Shift
So, where does this put the markets now? Has the temporary bear market rally finally given way to a broader selloff that could last for months? Or are we experiencing the birth pains of a broad rally in global risk assets?
Well, to recognize where markets may be headed, we often need to understand what can drive prices either higher or lower on a day-to-day and week-to-week basis. And more often than not, markets are driven by a balance between fundamentals and narratives.
So, what’s the difference here? Well, fundamentals look at how the underlying top-down economy could affect corporate earnings and hence, an investor’s overall return on their investments.
When markets are driven by narratives, on the other hand, investors are mainly betting on expectations that fiscal or monetary policies or broad geopolitical developments could affect the overall market direction despite what’s going on in the corporate earnings or the broader economic environment.
Now, while fundamentals are important, it’s likely today that markets are being driven by a broad market narrative.
So, what narrative is driving the markets today? Well, up until Friday, the critical narrative being watched by investors here in the U.S. and around the world was whether the Federal Reserve’s aggressive monetary policy would give way to a more accommodative stance next year. Some have dubbed this the “Powell Pivot.”
Certainly, headline inflation has increased this year, and the Federal Reserve has made some efforts to hike policy rates to curb rising prices. The idea here is that as businesses and households spend less, there will be less demand for goods and services, and hence, prices and inflation could subsequently fall.
So far, the Fed has raised rates four times this year and is expected to do so again at its three remaining meetings in September, November, and December. After that, market expectations had been that policymakers could “pivot”, or stop raising rates and keep them steady, maybe even start cutting interest rates in response to what’s expected to be a recession later this year or early next year.
Now, it’s essential to note that financial markets are in many ways a forward discounting mechanism. As Warren Buffet once put it, “in the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
The rally that we had seen in U.S. risk assets up until last Friday likely had to do with the notion that investors were betting that, even as the economy slows and likely heads into a recession this year, policymakers would likely pivot to a more accommodative stance (like stable or lower interest rates in the coming months).
It’s this narrative-effect that arguably led to the March 2020 rally during the height of the pandemic and also helped juice risk asset prices in 2009 during the Global Financial Crisis, which led to multiple rounds of Quantitative Easing (QE).
So, will they or won’t they?
By some measures, Friday’s Jackson Hole speech was not only disappointing, it in many ways it derailed what had been a time-tested narrative that the Fed would adjust policy to support an ailing economy and hence provide a boost to financial markets. The key takeaway from Jay Powell’s Friday speech is that rescuing the economy is not a priority for policymakers this time around.
Why?
Well, keep in mind that the Fed failed to catch the early signs of inflation when it first started accelerating last year. Since then, policymakers have been heavily criticized for calling inflation transitory when in fact, it was more persistent than expected.
From this perspective, Powell and the Fed are trying to save face and make up for a series of policy missteps from last year. Put differently, it appears that policymakers would rather err on the side of being too aggressive and tamp down inflation at the expense of economic growth rather than stopping too soon to save the economy, only to prolong its battle with inflation for years to come. For now, the expectation is that the Federal Reserve will continue to raise interest rates until the end of this year.
So, when will the pain end?
How long rate hikes continue and the magnitude of which will be dependent on incoming economic data. And of significance will be inflation data, and not just headline inflation, but namely the Fed’s preferred measure of inflation, which is PCE inflation, as well as producer prices, energy prices, import prices, and the like.
Put simply, inflation data will be essential to the Fed policy narrative and market direction in the coming months. With headline inflation seemingly turning a corner in July, all eyes will be on the August inflation report due out mid-September to evaluate whether the trend of slowing inflation has some legs.
As it stands today, however, markets still expect the Fed to raise interest rates by 75 basis points at its September 21st meeting and another 75 basis points by the end of the year, bringing the top-end of the Fed Funds rate to four percent!
This rate expectation reflects a more hawkish stance from the Fed combined with the Biden administration’s recent decision to forgive nearly half a trillion dollars’ worth of student loan debt.
Easing Inflation and Shallow Recession Essential to Market Sentiment
So, what does this mean for your investments?
Well, the difference between a short-lived bear market rally and the start of a new bull market likely will come down to how inflation plays out and how resilient the U.S. economy can remain in light of higher interest rates over the coming months.
One area that we’re closely watching as it relates to inflation is housing. Home prices have played a critical role in inflation this year.
For example, shelter makes up nearly a third of the overall CPI basket, and these prices were up nearly 6% on a year-over-year basis in July.
Higher interest rates have nevertheless contributed to weakness in the housing market, which could be a positive development for inflation down the road. For example, existing home sales are down 5.9% from where they were a year earlier, with sales declining for a sixth consecutive month in July. And some real estate firms like Redfin and Zillow are increasingly reporting homes selling for less than asking.
New home inventories have also spiked to levels not seen since 2009 as new home sales have plunged 39% over the past year. In other words, cooling housing market activity could ease rent pressures and subsequently help reduce this key measure of inflation.
At the same time, if energy prices continue to stabilize, agriculture production remains robust and geopolitical tensions in Eastern Europe ease, we could see further positive developments in the inflation story. For now, Friday’s post-Jackson Hole selloff was likely an excuse for traders to take profits after a strong run risk asset rally over the past month.
Nevertheless, we’re likely in for another choppy few weeks in the markets as investors parse through economic data leading up to the September FOMC meeting. At that point, we’ll have a better picture of how pleased policymakers are with the pace of inflation moderation and their willingness to once again support the economy and the markets in the months ahead.
However you cut it, Powell’s eight-minute speech derailed the market’s pivot narrative last week. What investors need now is another broad narrative to support their reason to invest in this uncertain market. Until they do, expect market conditions to remain volatile in the weeks and months ahead.
A Systematic Process for Navigating Market Uncertainty
That’s why it’s essential now more than ever to rely on a disciplined investment process to navigate this period of market uncertainty.
So, what do we mean by investment process? Simply put, we suggest 1) choosing the right mix of assets for a portfolio that aligns with your risk tolerances and objectives, 2) putting money to work in the markets in a disciplined manner, 3) rebalancing portfolios at regular intervals, and 4) finally having a cash management process in place.
Diversify your portfolio
Now, a systematic investment process begins with understanding your own tolerance for risk and adding a set of assets to an investment portfolio that that vary with your overall goals and objectives. What does this look like? Well, for investors with a low tolerance for market swings and a near-term need for access to their assets, a conservative allocation would likely reflect a bias toward more bonds and less stocks.
On the other hand, a more aggressive asset allocation framework could be appropriate for investors who can tolerate wide swings in the markets and have a longer investment horizon. Either way, a solid investment process begins with understanding your preference for risk and your overall investment horizon.
Dollar-cost averaging
The next part of the systematic investment process involves being disciplined with committing capital to an investment portfolio at regular intervals. As we pointed out earlier, trying to time the best and worst days of the markets might have an adverse effect on overall investment performance. To avoid such issues, we recommend dollar cost averaging, or more simply, committing a set sum of money to your investment portfolio on a regular basis.
What does this look like?
If you participate in an employer-sponsored retirement plan, this could involve setting up automatic payroll deductions and having capital committed to your portfolio every pay period regardless of market conditions. Or, a similar approach can be used for after-tax contributions or lump-sum transfers by scheduling cash allocations to your IRA or taxable investment account on a pre-defined schedule. Either way, putting capital to work at set intervals can help reduce cognitive load, simplify decision-making during periods of market volatility and keep your savings goals on track.
Rebalance your portfolio
Another step in the systematic investment process is portfolio rebalancing. Now, rebalancing is essential because, over time, the values of various assets within a portfolio will drift away from their initial allocations as markets move up and down. The purpose, then, of rebalancing is to realign portfolio holdings with their target allocations.
So, when should you rebalance?
Rebalancing can occur 1) on a set schedule, 2) when asset values drift by a certain threshold, or 3) in a combination of the two. For example, rebalancing on a set schedule could involve evaluating portfolio holdings quarterly, partially selling positions that have appreciated, and adding to allocations that have underperformed during that period.
Alternatively, using a threshold to rebalance could involve using a decision rule that prompts a rebalance only when the value of a specific asset class is a set percentage above or below its target allocation. This process could lead to less frequent rebalancing during flat markets but more rebalancing during periods of heightened market volatility.
Cash Management
Finally, if you're in the distribution phase of your investment journey, or in other words, dependent on your savings to pay for your living expenses, then cash management is essential for navigating market volatility without missing out on the best days in the market.
Now, a solid cash management technique ensures that you have access to enough liquid assets in your retirement portfolio to cover between 12-18 months of living expenses. Such investments can include money market mutual funds, and the purpose of this approach is to give your savings enough of a runway to avoid having to sell assets at an inopportune time when the markets begin to sell-off.
Bottom line
When it comes down to it, the Federal Reserve and indeed, many central banks around the world have committed to tamping down inflation and doing so at the cost of the economy at large. This means that we’re likely to see heightened economic and market volatility in the months ahead. Put differently, few individuals know which way the economy or markets will be headed in the next week, month or year.
That's why during times like the present, we challenge investors to ask themselves whether the decisions they are making are aligned with a systematic investment process. This approach includes committing to a target asset allocation framework, deploying capital to the markets in a disciplined manner, rebalancing as appropriate, and having a solid cash management process in place.
Whether you're looking to buy securities at a discount or avoid losses altogether, there's rarely a right time to get into the markets. Nevertheless, we believe that staying committed to a disciplined investment process and using techniques to manage uncertainty during periods of heightened market volatility could help you increase the odds of achieving your lifestyle goals regardless of market conditions and keep you on track to mastering your financial independence journey.
Another Recession is Here. Now What?
It's unofficially official: we're in an economic recession for the second time in two years. At least, that's according to government data published this week.
This news comes from the Bureau of Economic Analysis' latest report on economic activity, which showed that U.S. Gross Domestic Product, or GDP growth, contracted during April, May, and June, marking the second straight quarterly decline so far this year.
And by some measures, two consecutive contractions in GDP is considered the start of a recession.
What is a Recession?
So, with all of this talk about a recession, some of you may be asking, “what exactly is a recession?” Well, as of late, there's little consensus as to the definition of a recession. In fact, the White House has been working hard this week to redefine what it means to be in a recession. Nevertheless, a recession can be defined as simply a decline in economic activity over some time.
And it's important to keep in mind that recessions are not caused by a single event, but instead occur as a result of many factors, including rising interest rates, higher inflation, declining consumer spending and investment, falling production capacity and rising unemployment.
Now, our country has been through 48 recessions since its founding. And since 1947, when government statistics were gathered more consistently, data show that we've been through about twelve recessions in the past 75 years.
Of those twelve recessions, ten of them have occurred when two quarterly GDP declines were in place. So, from this perspective, if we use history as our guide, we could safely say that a two-quarter decline in GDP growth is consistent with a recession.
So, Are We in a Recession?
Now, it's important to note that while we've experienced two consecutive declines in economic growth, the official measure of a recession is often broader than looking at GDP alone.
To be sure, the National Bureau of Economic Research, or NBER, considers several indicators before officially calling a recession. They look at what’s going on in the labor market, consumer spending, industrial production, and other measures before calling slowing growth a recession.
While some of these indicators have softened recently, they’re generally in what appears to be still positive territory. With that said, if we look back to the Great Recession, we find that while the NBER called the recession starting in December 2007, industrial production didn’t roll over until April of the following year.
We can even go back to the recession of 2001 around the Dot Com bust to find that there’s no singular measure of a recession. For example, while the NBER called a recession starting in March 2001, GDP did not even go through a two-quarter contraction during this period. Nevertheless, U.S. economic activity did experience a decline broad enough to have been considered a recession.
With all that said, the NBER does not have a track record of calling recessions in real-time, and often they confirm their findings only months after a recession has already begun or ended.
So, are we in a recession? Well, the short answer to this question is likely yes.
While the NBER hasn't officially come out and called a recession yet, there's a solid reason to believe that we may be in one today. Again, over the past 75 years, there's been a couple periods where the economy experienced a two-quarter decline, and a recession did not occur, and that was in 1947.
Since then, every recession has been accompanied by a two-quarter decline in GDP like we've experienced so far this year.
How Does a Recession Affect Me?
Now, given all the headlines surrounding recessions, you might wonder how today's current events affect you.
Well, how a recession might affect you depends on your situation and where you're at in your financial independence journey.
If you are in the accumulation phase, saving money and preparing for your definition of financial freedom, you may have some obstacles to navigate in the months ahead. For instance, layoffs tend to rise during economic downturns, so having an emergency cash reserve on hand to deal with a potential unemployment situation will be essential to navigating this period of economic uncertainty.
With that said, if your emergency savings are topped up, and you're feeling confident about your current job prospects, then a recession might provide you with an opportunity to buy financial assets at a discount or invest in distressed real estate or other business ventures as the economy weakness.
Now, you'll likely find yourself with a unique set of challenges if you're an individual in the distribution phase of your financial independence journey. For example, market pullbacks or bear markets often accompany recessions.
And by many measures, we're already in a bear market today.
So, if you're currently dependent on your investment savings to cover living expenses during retirement, then taking distributions from your portfolio when prices are down could mean locking in market losses at an inopportune time.
If you've been following along with our commentary over the past few months, however, then you'll likely know how imperative it is to have an adequate cash reserve to cover 12-18 months of living expenses during this time.
This cash buffer can allow you to maintain your standard of living even during a recession-induced bear market, while giving your portfolio enough time to recover once the economic outlook clears up.
While recessions can be devastating to individuals, businesses, and the economy at large, they are not always a bad thing: when the economy contracts it means financial resources are being allocated more efficiently. And this can help to correct imbalances within the system, especially after an extended period of loose monetary and fiscal policies and free-wheeling market conditions.
Fortunately for most people, it's possible to weather even severe economic downturns as long as you're prepared financially and emotionally.
Preparing for a Recession: Start with Your Plan
So how should you position your finances for weaker economic growth and heightened market volatility in the months ahead? Well, if you're an individual focused on mastering your financial independence journey, the short answer is to stay committed to executing on your long-term financial plan.
During times of economic and market uncertainty, for some of us, there's a tendency for our vision to narrow to the present, tempting us to change the way we handle our finances or investment allocations as a way to mitigate what appears to be an immediate financial threat.
Even so, if you have a well-structured financial plan and a disciplined investment process already in place, then the action that you'll likely need to focus on today is consistently doing the work necessary to execute your plan.
To be sure, if you have a well-crafted financial plan already in place, then those actions should be defined in your implementation schedule. Otherwise, developing a set of strategies to align your financial resources with your long-term goals should be a priority if you don't already have a comprehensive financial plan in place.
Certainly, a solid financial plan lays out how to connect the dots between your financial resources and ideal long-term lifestyle goals. At the same time, it identifies predefined strategies and tactics that you can tap into to manage adverse conditions when they inevitably arise in the near term.
Have Adequate Cash on Hand
Once your financial plan is in place, the next thing you'll likely need to focus on is getting back to the basics.
What do we mean by getting back to the basics? Well, what we mean here is ensuring that you have enough cash on hand to weather the impending economic storm, whether you're dependent on a job or a retirement nest egg to cover your household income needs.
When it comes to managing your portfolio during a recession, there's no substitute for cash. Sometimes it can be hard to get excited about cash, but in a recession, having some money in reserve can save your investments and keep their value whole while waiting out the downturn.
Cash is also necessary because it's a great way to rebalance your portfolio back toward its original goals if something causes some of your investments to perform poorly (which often is inevitable!).
Having cash on hand to be able to buy more shares of one security or another when prices decline may enable you to take advantage of opportunities and spread risk across various asset classes. This is one reason why we advocate for maintaining investment exposure across stocks, bonds, and real estate in both U.S. and international markets.
Assess Your Current Portfolio
The next step for investing during a recession is to get a good picture of your current portfolio. What's in it? How much risk are you taking? What are your investment goals, and how much risk can you stomach?
Now that you have a good understanding of where you stand, think about how to protect yourself during an economic downturn.
Don't Panic and Don’t Sell Everything
One essential way to safeguard your investment portfolio is to protect it from yourself. While headlines will focus on the negatives that recessions often bring, you'll likely need to remember that this is not the end of the world—it is just a temporary setback.
You likely already went through this back in 2020 and made it through in one piece.
Certainly, no one can predict what will happen next, but if you sell everything now, you may be selling at a loss and will regret it later.
Another Recession is Here. Now what?
When it comes down to it, various indicators suggest that we're likely already in a recession. And this time around, the government likely won't be ready to cut checks and support the economy as it had in the past.
That's why if you're serious about mastering your journey to financial independence, then now's the time to ensure that you have a solid financial plan in place, that your investment strategy is aligned with your long-term plan and that you're effectively executing on your implementation schedule.
If you are afraid of losing money in your investments, don't panic and sell everything; instead, get some professional advice from someone who knows what they're doing.
Most investors get through downturns just fine if they have a little patience and a good strategy.
Many investors who lost money during the Great Recession or during the Pandemic did so because they didn't have a diversified portfolio or got out of the markets altogether.
And there's no such thing as a perfect investment strategy. But if you have a plan and stick to it, you'll be in better shape than most.
If you've been through a recession before, you know how difficult it can be. But if you have a solid strategy and stick to it, it doesn't have to be all that stressful. The key is to have enough cash on hand to navigate market and economic uncertainty.
And again, stay calm and don't panic sell your investments just because there's bad news out there! Remember: recessions come and go. But over time, they can provide tremendous buying opportunities and allow the value of a diversified portfolio tends to go up in value over the long-term if bought at reasonable prices.
Is now the right time to get into the markets?
With risk assets having pushed into bear market territory in May, some investors are asking whether now is the right time to get into the markets. On one side of this debate is a group of investors who look at the recent pullback as an opportunity to buy securities at a discount. On the other side is a set of investors concerned that prices will only move lower from here. Make no mistake, this question is relevant to investors today not only because of the magnitude but also because of the breadth of recent market declines.
For example, if we consider year-to-date performance for the S&P 500 index, what we find is that the first one hundred days of this year's market performance have been brutal. Indeed, through the end of May, the data show that U.S. Large Cap stocks have had their worst year-to-date decline in the past forty years. Adding insult to injury, investors have had little place to hide given the fact that stocks and bonds across U.S. and international asset classes have all posted losses this year.
So, why are markets selling off across the board? Well, the reasons behind this seemingly correlated selloff across major asset classes are manifold. But at its core, persistently high inflation and the prospects for an impending U.S. recession given ongoing logistics issues, healthcare concerns, and the war in Eastern Europe have made market participants more sensitive to the effects of less favorable central bank policy and the weaker corporate earnings outlook.
Now, in the past, market participants could look to policymakers to bolster the economy and markets when similar weak or uncertain macroeconomic conditions were present as they did back in 2020. But today, that story has changed. With headline inflation well above 8% this year, Federal Reserve policymakers are keen to continue raising interest rates, even if that means forcing the U.S. economy into a recession.
At the same time, businesses likely will find it increasingly challenging to keep passing along rising prices to consumers as wage growth has failed to keep up with inflation and household pocketbooks become increasingly stretched.
With the economic backdrop poised to weaken, and asset prices declining across the board, is now the right time to get into the markets? Well, with market sentiment being driven by the macro narrative, it can be argued that current economic conditions depend on many factors for which we yet have little clarity. For example, can the world avoid massive food shortages this year and next with a war raging in Ukraine? And, has inflation peaked, and if so, when will it stabilize enough for the Fed to stop pushing borrowing costs higher and higher?
While the answers to these questions are debatable, what is clear is that market participants have a host of broad-based macroeconomic concerns that still need to be worked out. And from this perspective, the prospect of continued volatility across asset classes suggests that timing market entry points (whether that's buying at a discount or avoiding the markets altogether) may be challenging for even the most seasoned investors.
Therefore, in the current environment, we believe that the question investors should be most concerned about is not how to time the markets but rather whether they have an investment process in place to withstand this period of heightened market uncertainty.
Missing the best days in the markets
Indeed, some investors may be enticed to use timing techniques or other short-term strategies in a bid to boost overall returns or to avoid losses completely. Such approaches involve exiting risk assets in anticipation of market moves lower and ratcheting risk back up as market sentiment improves. While such an approach sounds reasonable, getting the timing wrong could be more costly than beneficial.
How so?
Well, one analysis shows that over a 20-year period, missing even the 10-best days in the market would have led to returns of more than half the rate of those made by investors who stayed committed to the markets during up and down periods.
How is this possible?
Well, history shows that some of the best days in the markets typically follow the worst selloffs. This insight means that investors who had taken money out of the market in fear of a move lower could miss the beginning of a long-term rally. This reality was evident as recently as the COVID-induced market pullback in early 2020 and the subsequent risk asset rally through the end of 2021.
So, what's the point?
Well, unless you have the time, inclination, and experience, getting the timing right on a trade in your portfolio because you're debating whether you should (or shouldn't) get into the markets may cost you more than it is ultimately worth over the long run.
Finding the winning trade
This timing discussion also raises the question about trying to spot winning and losing trades. This attempt to time the market is especially tempting when yesterday's winners are beaten down and appear to be deep value opportunities or a bargain-buy.
Another temptation during the market selloff is chasing what appear to be winning asset classes and avoiding those asset classes that appear to be losing trades. The problem with trying to separate winners from losers, notably during a time of heightened market volatility, is that investor sentiment can shift on a dime, leaving many a portfolio in disarray.
Indeed, some data show that today's best-performing asset class could be tomorrow's laggard and vice versa.
What's more, the variability between stocks and bonds and even domiciles like the U.S. versus international investments tend to vary in performance from one year to the next. That's why an investment portfolio utilizing a diversified asset allocation framework and rebalanced at regular intervals tends to perform more consistently and avoids the wide swings associated with staking a claim in any one asset class. This finding leads us to our final point: a systematic investment process can add more value over time than trying to time the markets.
A systematic process for navigating market uncertainty
To be sure, even some of the best asset managers have had a hard time beating the markets over the past decade, which underscores the importance of a solid investment process. What do we mean by investment process? Simply put, we suggest 1) choosing the right mix of assets for a portfolio that aligns with an investor's risk tolerances and objectives, 2) putting money to work in the markets in a disciplined manner, 3) rebalancing portfolios at regular intervals, and 4) finally having a cash management process in place.
Diversify your portfolio
Now, a systematic investment process begins with understanding your own tolerance for risk and adding a set of assets to an investment portfolio that that vary with your overall goals and objectives. What does this look like? Well, for investors with a low tolerance for market swings and a near-term need for access to their assets, a conservative allocation would likely reflect a bias toward more bonds and less stocks.
On the other hand, a more aggressive asset allocation framework could be appropriate for investors who can tolerate wide swings in the markets and have a longer investment horizon. Either way, a solid investment process begins with understanding your preference for risk and your overall investment horizon.
Dollar-cost averaging
The next part of the systematic investment process involves being disciplined with committing capital to an investment portfolio at regular intervals. As we pointed out earlier, trying to time the best and worst days of the markets might have an adverse effect on overall investment performance. To avoid such issues, we recommend dollar cost averaging, or more simply, committing a set sum of money to your investment portfolio on a regular basis.
What does this look like?
If you participate in an employer-sponsored retirement plan, this could involve setting up automatic payroll deductions and having capital committed to your portfolio every pay period regardless of market conditions. Or, a similar approach can be used for after-tax contributions or lump-sum transfers by scheduling cash allocations to your IRA or taxable investment account on a pre-defined schedule. Either way, putting capital to work at set intervals can help reduce cognitive load, simplify decision-making during periods of market volatility and keep your savings goals on track.
Rebalance your portfolio
Another step in the systematic investment process is portfolio rebalancing. Now, rebalancing is essential because, over time, the values of various assets within a portfolio will drift away from their initial allocations as markets move up and down. The purpose, then, of rebalancing is to realign portfolio holdings with their target allocations.
So, when should you rebalance?
Rebalancing can occur 1) on a set schedule, 2) when asset values drift by a certain threshold, or 3) in a combination of the two. For example, rebalancing on a set schedule could involve evaluating portfolio holdings quarterly, partially selling positions that have appreciated, and adding to allocations that have underperformed during that period.
Alternatively, using a threshold to rebalance could involve using a decision rule that prompts a rebalance only when the value of a specific asset class is a set percentage above or below its target allocation. This process could lead to less frequent rebalancing during flat markets but more rebalancing during periods of heightened market volatility.
Cash Management
Finally, if you're in the distribution phase of your investment journey, or in other words, dependent on your savings to pay for your living expenses, then cash management is essential for navigating market volatility without missing out on the best days in the market.
Now, a solid cash management technique ensures that you have access to enough liquid assets in your retirement portfolio to cover between 12-18 months of living expenses. Such investments can include money market mutual funds, and the purpose of this approach is to give your savings enough of a runway to avoid having to sell assets at an inopportune time when the markets begin to sell-off.
Bottom line
When it comes down to it, asking whether now is the time to get into the markets often misses the point of what it means to be a long-term investor. To be sure, trying to time the markets and hoping to find the next "fat pitch" or winning trade are demeanors often associated with speculative behavior. And, as we have pointed out earlier, such behavior can lead to unfavorable investment outcomes over the long term.
That's why during times like the present, we challenge investors to ask themselves whether the decisions they are making are aligned with a systematic investment process. This approach includes committing to a target asset allocation framework, deploying capital to the markets in a disciplined manner, rebalancing as appropriate, and having a solid cash management process in place.
Whether you're looking to buy securities at a discount or avoid losses altogether, there's rarely a right time to get into the markets. Nevertheless, we believe that staying committed to a disciplined investment process and using techniques to manage uncertainty during periods of heightened market volatility could help you increase the odds of achieving your lifestyle goals regardless of market conditions and keep you on track to mastering your financial independence journey.
Inflation, Banking Crises and Recession: Position Your Money for Success
If you had to guess how financial markets performed in the first quarter based solely on news headlines, what would you find?
Performance was likely quite poor, right?
Well, the truth is that markets held up quite well in the first quarter, but I wouldn't blame you if you guessed that it was just another disappointing repeat of what we saw last year.
To be sure, after news of markets swooning back and forth on optimism and pessimism on central bank policy, stubbornly high inflation, the prospects of another banking crisis, and the ongoing talks about a recession, there certainly is a lot for the markets to be worries about these days.
Even so, market sentiment has remained buoyant even as a host of worries continue to capture news headlines.
So, given how resilient markets have been in the first quarter, the big question now is, "where do we go from here?" Indeed, could the positive start to the year be a sign of a sustained risk asset rally through the end of 2023?
Well, the short answer is, maybe.
You see, while markets have taken many of this year's bad events in stride, history tells us that we're likely not out of the woods yet as far as how outstanding negative events could dent market sentiment. Even so, it's possible that investors could look past historic precedent on their way to a renewed rally after last year's bear market sell off.
Inflation is What it's All About
Now, truth be told, where the markets land by the end of the year is anyone's guess. If I had a crystal ball and could tell you where the markets are headed with certainty, I'd likely be the richest man in the world. Even so, one factor likely to drive market direction either higher or lower this year is inflation.
And why's that?
Well, that's because inflation is affecting all of our lives in material ways. Certainly, weeks ago, we saw headlines about how basic staples like a dozen eggs and snack foods like a 7.5-ounce bag of your run-of-the-mill potato chips fetched as much as $7.00 each. And these anecdotes only point to the broader problem of housing affordability, the price of new and used cars, and how expensive many of the goods and services we depend upon have become over the past few years.
At this point, the key issue for the markets is that if policymakers demonstrate that they can't get inflation under control, then we'll likely have a new set of challenges to deal with.
Now, the truth is that inflation is a phenomenon that we've dealt with for time in memoriam. However, the reason that inflation is a concern right now is because when consumer expectations of inflation remain elevated, or what policymakers call "unanchored," it has a lot of unintended economic and social consequences.
And while inflation has been slowing in recent months, according to the University of Michigan's latest survey of households, individual expectations of inflation remains elevated. Indeed, in its February survey, data showed that consumers expect inflation to end around 4% in about a year from today. And while this expectation is an improvement from the near 5.5% level we saw last year, it remains well above the 2.5% figure we saw in the months just before the pandemic started.
At the same time, the Richmond Fed's quarterly survey of CFOs shows that business leaders expect inflation to remain around 5% over the coming year. What this means is that the household and business expectation surveys are still way above the Fed's 2% inflation target.
The point here is that the data show that the air has yet to entirely come out of the inflation bubble, especially when it comes to what people expect about inflation. And as we pointed out in previous reports, inflation tends to become a self-fulfilling prophecy, which is why officials are so keen to put it to bed.
What this means is that as long as the data show that inflation is still running hot, and workers and business owners alike are feeling it, then policy rates likely will need to remain higher for some time so that the US economy will eventually slow to the point where prices are less of a concern, and staying solvent is.
Boring Bonds Bring Down Banks
Now, the thing about the Fed pushing rates higher is that it has had knock-on effects across all aspects of the financial system, especially in the bond market. You see, in this sleepy corner of the market, when interest rates go up, the price of a bond goes down. And under normal circumstances, these price swings are par for the course when it comes to investing.
But, what's different this time is that US banks hold a lot of Treasurys, or US government bonds, as assets on their balance sheets. Now, banks hold these assets for various reasons, but one of them is to ensure that they can absorb losses in the event of an economic downturn.
Typically, when the Federal Reserve tightens its policies, banks and other financial institutions are able to look past the falling value of their bond portfolios as interest rates move higher in a steady fashion.
Now, that's not what happened over the past year as officials raised rates aggressively, catching some banks flat-footed. Indeed, we learned in March that many US banks had become overly complacent with how they manage their otherwise boring bonds, contributing to the failure of several highly visible banks and sparking widespread worry that a financial crash was on the horizon.
And while policymakers were able to quickly avert a widespread crisis following the collapse of Silicon Valley Bank, the event itself has sparked greater caution across the broader banking system.
For example, financial institutions, on the whole, are now tightening lending standards and granting fewer loans. What's more, many of these organizations have announced layoffs across various lending groups, including mortgage and auto lending, and are increasing their loan loss reserves in anticipation of borrowers simply giving up on their expensive loan payments.
Now, on the surface, a decline in lending activity is generally bad for the economy. That's because when it's more challenging for a business to obtain financing to keep its operations going, managers tend to lay off employees to free up working cash flows. And when households are facing potential job losses and the prospects of lower available credit lines when banks tighten lending standards, consumer spending tends to slow.
The silver lining is that falling bank lending, slower business and consumer spending, and slowing economic activity, in general, can have a more significant effect on curbing inflation than a central bank solely pulling the lever on higher interest rates.
What this means is that if banks aren't lending as freely as they were because they're now worried about a recession, then businesses and consumers alike are likely to spend less on goods and services, which could cause the rate of inflation to slow further in the months ahead.
What it All Means for Your Investments
So, where does all of this leave us in terms of the market outlook for the coming quarter? Well, market participants so far have been able to look through all of the worries about the banking sector which is evidenced in the positive performance we saw in risk assets in the first quarter.
Even so, inflation continues to remain the dominant catalyst for whether the markets manage to move higher throughout the second quarter of the year and beyond. That's because investors are primarily focused on what the Fed will do next, and taming inflation remains the Fed's number one priority for the year.
Now, some may argue that inflation is, in fact, coming down, but the reality is that it's not falling as fast as policymakers would like. And that's one reason why so many Fed officials remain vocal about the central bank's need to continue raising interest rates this year.
Nevertheless, many investors are looking past what the Fed will do in anticipation that tightening bank lending standards and the potential for lower spending amidst recession worries could give the Fed less of a reason to continue raising interest rates later this year. And when the Fed stops raising rates and finally signals that it's ready to ease its grip on a tight monetary policy, that likely will be the moment when investors begin to breathe a sigh of relief, and risk assets subsequently take off.
With that said, history has shown that sustained market rallies generally do not take place until the Fed begins cutting its key policy rate. And, again, based on what we've been hearing from various Fed officials in recent weeks, rates hikes are still on the table.
So then, where does this leave the markets? Well, you'll recall that markets are often considered to be discounting mechanisms because they incorporate all available information and, more importantly, expectations about future events into current asset prices.
In other words, market participants use all available information to make informed decisions about the value of a particular asset, and these decisions are reflected in the market prices.
So, then, from this perspective, we can argue that risk asset prices have been moving higher in recent months because investors anticipate an eventual rate cut by the end of the year. Now, whether inflation is tame enough by year-end to warrant rate cuts is hard to say. That's because few things about how the economy functions have been standard textbook over the past few years.
Either way, market participants are likely now betting that a credit crunch and the prospect of an economic recession could be enough to cause policymakers to finally pivot to rate cuts, confirming investors' expectations and supporting the current market rally through the end of the year.
So, what does this mean for your investments?
Well, a great deal of uncertainty remains about the timing of the change to Fed policy. Remember, markets have been betting that the Fed would "pivot" and cut rates for nearly a year now. And every time they were wrong, risk assets sold off sharply as a result.
Indeed, what last year's market experience taught us is that even the brightest and most talented professional investors got many of their bets wrong. Therefore, if you're trying to time your way into and out of the markets, it will likely cost you more than you will gain over the long term.
At the same time, what this outlook means to you is that it's essential to stay invested for the long term and avoid the temptation to hide in cash. To be sure, while concerns about a broader banking collapse and the prospect of recession are warranted, it's worth remembering that we've been through worse over the past few years, and markets have nevertheless charged higher.
Either way, the big takeaway here is that there's reason to remain optimistic about the markets in the year ahead. But until we get clarity on the path of inflation, and hence Fed policy, trying to get cute in the markets likely will cost you more than it's worth.
Financial Planning Housekeeping Items for the Quarter
Now, as we wrap up our outlook for the quarter, let's quickly cover some financial planning topics that will set you up for success into the remainder of the year.
Rebalance Your Investments
To start, take a moment to review your investment and retirement portfolio. You know, the recent positive market performance has offered a unique opportunity to rebalance as asset prices have moved higher this year. So, if you haven't done so already, take a moment to consider your current holdings versus your target allocations and sell positions that have done well, and add to those that are underallocated.
Now, why would you want to do this? Well, remember that over time, the performance of different asset classes can vary, causing your portfolio to deviate from its target allocation. And with many risk assets rallying into the start of the year, now may be the time to check whether your current holdings, especially in your employer-sponsored retirement accounts, reflect your long-term asset allocation strategy.
Make Your Quarterly Tax Payment
The next planning topic to consider is your estimated quarterly tax payments. Now, with tax season largely behind us, now is a great time to ensure that you're prepared to make your estimated quarterly tax payment for the month of April if you haven't done so already.
And why is this important?
Well, making estimated quarterly tax payments to the IRS can help you avoid any penalties for underpayment of taxes, help you better manage your cash flows, and stay organized with your finances.
And by making regular payments, you can track your tax liability and avoid any surprises at tax time, as well as spread out your tax payments throughout the year to avoid a large, unexpected tax bill next April.
Manage Your RSUs
Next, if you have RSUs (restricted stock units) that have vested in the first quarter, now may be a great time to consider your options for your holdings. And if you need pointers on understanding or managing your equity award, be sure to check out the resources we published last quarter about managing this critical component of your overall compensation.
Either way, the recent runup in risk assets may provide you with a great opportunity to lock in your company stock price at a higher level, given that we anticipate increased levels of market volatility into the rest of the year.
Check Your Cash Reserves
Finally, with market and economic volatility likely to remain elevated in the months ahead, given the prospects of a credit-induced recession this year, it's crucial now more than ever to have an adequate cash buffer that you can rely upon.
Why?
Well, picture this: you run into an emergency, like a medical bill, your furnace needs replacing, or you're dealing with an untimely car repair.
How are you going to pay for these expenses?
And in a recession, job loss or reduced income can happen to anyone, and it's not fun. But guess what? With a cash buffer, you've got some breathing room. You can cover your living expenses while you search for a new job or adjust your budget, all without the stress of piling on more debt.
And here's another thing: having that cash buffer means you won't need to rely so heavily on credit. With tighter lending standards already underway, getting credit becomes more difficult anyway. So, by having your own financial cushion, you're taking control of your financial life, and that's something to be proud of.
Inflation, Banking Crises, and Recession: Position Your Money for Success
Taken together, the first quarter of 2023 demonstrated that markets can, at times, remain resilient despite ongoing challenges, such as high inflation, bank crises, and a potential recession looming in the background. That's why as we move forward into the rest of the year, it's essential to keep a close eye on these factors and remain vigilant in monitoring how they may impact your finances.
Now, despite the uncertainty, it's essential to maintain a long-term perspective and avoid knee-jerk reactions based on short-term market fluctuations. Indeed, by focusing on a holistic financial planning approach, you can prepare yourself for both the ups and downs of the market and ultimately, build a secure financial future.
This approach includes revisiting your investment portfolio to ensure it aligns with your long-term goals, making timely quarterly tax payments, managing your RSUs wisely, and checking in on your cash reserves. And by addressing these financial planning housekeeping items, you can optimize your finances and navigate the potential market and economic volatility ahead with greater confidence and peace of mind.
In the end, while the markets may continue to test your nerves with its unpredictable twists and turns, a well-rounded financial plan, coupled with a steadfast commitment to long-term goals, can help see you through even the most challenging of times, but more importantly, take you one step closer to becoming the master of your financial independence journey.