Take a Breath, Reflect and Improve
FIVE THINGS YOU SHOULD KNOW
- Equity Markets – were mixed this week with U.S. stocks (S&P 500) up 1.82% while international stocks (EAFE) fell -0.01%.
- Fixed Income Markets – were lower with investment grade bonds (AGG) down -1.85% while high yield bonds (JNK) fell -1.33%.
- European Pact – in efforts to dampen its reliance on Russian energy, the European Commission announced a pact with the United States to bolster Europe’s supply of liquid natural gas by year-end. President Biden also met with NATO leaders this week to discuss increasing pressure on Putin and the removal of Russia from the G-20 group of major economies.
- Yield Curve – the spreads between 10-year and 2-year Treasuries have narrowed to its lowest level since the pandemic began on comments from Jerome Powell that the Fed may look to hike rates by as much as 50 basis points at the next meeting – a reversal from his Fed comments last week. Ongoing inflation has sparked global bond selloffs, with the Bloomberg Global Aggregate bond index down almost $2.6 trillion in market value from its January peak.
- Key Insight – [VIDEO] With equity markets posting their first back-to-back positive weeks this year, we take a moment to catch our breath, reflect, and see what we’ve learned. [ARTICLE] As the Fed finally lifts their key interest rate for the first time in years, we discuss what their actions are about, why they spooked investors, as well as why investors shouldn’t allow their fears to scare them away too early.
INSIGHTS for INVESTORS
Investors tend to be very binary; things are good (bullish) or bad (bearish) and therefore they conclude, risk assets should be bought or sold. The reality, as is the case with most things, is a bit more complicated.
The perfect example is to think about the Federal Reserve beginning its process of raising rates and shrinking its Treasury holdings with its decision to raise rates for the first time in years by a quarter of a point last week.
In the post Great Financial Crisis era, the Federal Reserve has come to play a MUCH larger role than it ever has historically and so its actions certainly bear watching. However, some investors seem to be set to hit the panic button a bit prematurely.
Why?
We’ll discuss shortly, but first what is all the rate hike business about anyway? Simply put, when the Fed believes the economy is growing too quickly, and as a consequence inflation along with it, it raises rates (e.g., borrowing costs) to slow it down. The idea/hope is to raise rates just enough to bring things back under control (i.e., inflation rates of about 2-4% annualized) without causing a recession (e.g., a “soft landing).
So why do some investors react to the beginning of this rate hiking process with panic or at the least, anxiety? Because the Fed has a miserable track record of actually accomplishing a “soft-landing” for the economy.
However, there are a number of reasons to suggest that investors selling in earnest today could leave significant returns on the table.
Analyst Tom Essaye did an excellent job summarizing the current environment and likely the near to intermediate term impacts of rising rates on the markets.
He stated …
What’s The Real Impact of Rising Rates?
“The rise in Treasury yields has accelerated and the Fed is using essentially every opportunity to tell the public that rates are going to rise even more in the coming months. So as we all embark on this potentially steep rise in rates, I wanted to take a minute to see what effect rising rates have had on the “real economy,” because one of the biggest risks to the market right now is an economic slowdown—and understanding when rates reach a level where that might occur is very important.
To do this, we looked at rates of several important consumer loans: 30-year mortgages, 5/1 ARMs, 60-month auto loans, HELOCs and credit card debt.
And the conclusion for all these loans was clear: Rates aren’t yet at levels that we think will restrict growth (and in some cases they are still far from levels that would restrict growth).
With the exception of the 30-year mortgage (which arguably is the most important of these consumer loans), none of the other major consumer loans are meaningfully above levels seen in January 2021, when economic growth and inflation were both more subdued.
5/1 ARMs, HELOC rates, car loans and credit card rates are all essentially at the same place they were in January 2021, and in all these cases they are below levels in January 2020 (pre-pandemic), a time when consumer balance sheets weren’t as strong as they are right now.
Now, mortgage rates have risen, and they are above pre-pandemic levels. But they are still well below the January 2019 levels, and that’s notable because early to mid- 2019 was the last time we saw a meaningful loss of eco-nomic momentum, which prompted the Fed to halt balance sheet reduction and rate hikes in mid-2019.
Bottom line, while Treasury yields have risen, and that’s caused mortgage rates to accelerate, the majority of other important consumer loan rates have not risen substantially.
What Does This Means for Markets?
We and others have said consistently that Fed rate hikes eventually choke off economic growth, but how many hikes and how long it takes is a function of 1) How low rates are at the start and 2) How strong growth is when rates begin to rise.
Right now, rate “lift off” is starting very low and economic growth remains very strong, and this analysis of consumer loans reinforces this point: It’s going to take a while for the Fed to choke off the economic recovery, even if they raise rates 50 bps at the next meeting. That underscores the point that a 10s-2s inversion is a warning that it’s coming—not an immediate sell signal.”
Assuming his thoughts have allayed some of your potential concerns, let’s consider what has historically occurred in the initial years of rate hike periods. On that note, Goldman Sachs shared the following, “Elevated inflation and a tight labor market have prompted the Fed to raise policy rates for the first time since 2018. While higher rates may increase the cost of borrowing, the S&P 500 has historically delivered positive returns over the past six Fed hiking cycles, averaging a 9.5% annualized return. We believe significant policy room exists before rates challenge equity returns.”
Summary
In closing, the likely path of the markets and economy over the next 12-24 months, while bumpy, does not suggest one should panic and abandon all risk assets just because the Fed has begun to raise rates. As discussed above, history and current levels strongly suggest that there is room in this cycle for more gains to be achieved.
However, for those who have become too complacent about risk and continue to allocate in a way that is not aligned with their true risk tolerance or timelines they should note that the Fed has historically never pulled off the much vaunted “soft landing”, and the yield curve should not entirely be ignored as it hints at a recession on the horizon.
Define your plan, follow your process, and have a partner to keep you accountable and you need not live in fear of whatever does lie ahead.
Have a wonderful weekend,
Tim and the team at TEN Capital