Both stocks and bonds continued their downtrend in the third quarter as the S&P 500 and Bloomberg Aggregate Bond Index fell -4.88% and -4.70% respectively. However, October proved to be a promising month as equity markets rallied off their lows in the face of speculation regarding the Federal Reserve and surprisingly positive economic data. Bonds, however, have been left behind with higher borrowing costs and persistent inflation.
While many challenges lie on the horizon, one in particular has captured the market’s full attention. Will the Federal Reserve do enough to bring down inflation?
Options for the Fed
Given they are already pursuing a strategy of QT (quantitative tightening), the main tool to fight inflation is the federal funds rate, the rate at which banks borrow from each other. Raising this rate, in theory, should increase borrowing costs for consumers, slowing demand and spending, and finally cooling inflation. While we have projected the 4th quarter to be in “Winter,” a growth slowing period, based on our four-season approach, economic data has been more resilient than both we and the market expected. This points to inflationary pressures remaining, thereby requiring the Fed to raise rates higher than currently forecasted. The Fed has already raised rates several times this year and is projected to continue.
Last week, the Fed raised rates by 0.75%. While this is exactly what the market expected, Federal Reserve President Jerome Powell’s comments were not. In his speech, he mentioned several instances of “more work to be done” and “not thinking about pausing,” suggesting a higher terminal federal funds rate. We expect the Fed to follow a similar path for their next few meetings, working to bring inflation down well into 2023. From our last quarterly update, we highlighted the risk of recession in the coming year. These risks still exist and now could coincide with rising rates, a bleak outlook for markets.
When and How Does it End?
President Jerome Powell has been adamant that they will stop raising rates when economic data and inflation show substantial cooling. Both of those metrics remain hot with the economy still chugging along at a surprising pace. Investors should expect frequent bouts of volatility and lack of strength in both equity and bonds. As the old saying goes, don’t fight the Fed, and this week, they told us not to.
Traditionally, in periods of low growth, there would be an offsetting effect of quantitative easing, which helps support the value of interest rate sensitive assets such as bonds, real estate, and utilities. Now, we could be left with a scenario where all sectors of the economy struggle due to these combined effects. As seen this year, a bear market in both equities and fixed income is incredibly hard to navigate.
What Can Investors Do?
While this outlook is discouraging, there is some good news. The Fed is likely to cause short-term pain for markets but, if they succeed in quelling inflation, the longer-term outlook for the economy is much more positive. Entrenched inflation, otherwise known as stagflation, is detrimental and would greatly decrease long run return potential for markets. Amidst the pain however, we will likely see dollar related investments, energy stocks, and commodities continue their outperformance until inflation has meaningfully turned around while tech companies could see stretched margins.
How Can We Help?
At GGM, aligning your investments with the prevailing economic environment is just one of the ways we strive to add value to your portfolio. If you are concerned about whether your investments are primed for the current market and allocated to meet your objectives, we recommend our complimentary portfolio checkup. Contact us today!
