Coasting (Further) Down the Mountain
- The intention this week was to let the market know what it essentially already knew – that this would be the last 0.75% rate increase and that the Fed would begin to slow rate increases.
- Wednesday’s FOMC Statement was perceived as dovish and immediately sent stocks higher.
- The presser had a more hawkish tone that quickly reversed the bullish stock market swing.
- These events can be confusing, but when viewed as the Fed attempting to coast down the mountain, everything makes more sense.
- Bottom line: So far, so good, but watch the economy for a Fed judgement error.
The great problem with communication is that it isn’t the message you think you are sending that is important. It is the message that is received that really matters. And that is Fed Chair Powell’s continuing problem as he attempts to coast down the inflation mountain. The intention this week was to let the market know what it essentially already knew – that this would be the last 0.75% rate increase and that the Fed would begin to slow rate increases. The almost unavoidable risk for Powell, was that the written statement would be taken as too dovish or too hawkish, requiring him to provide a ‘mid-course correction’ in the presser that followed later in the day. This is how each meeting/presser has been functioning for a long time and from that perspective, this week was no different.
Wednesday’s FOMC Statement was perceived as dovish and immediately sent stocks higher, naturally. What followed in the presser was a more hawkish tone that reversed the bullish stock market swing. But this time, Powell got fooled. Here is why this week was different.
When Chair Powell headed to the podium for the presser he was well aware that the stock market had headed north. In the Q&A session, a journalist asked a leading question, implying that the stocks were still rallying, even though Powell’s opening hawkish tone had already turned the markets around. Powell, of course, is unaware of the market reversal, and thinking that his initial comments were not hawkish enough, he doubled down on the hawkish comments. The result? He unknowingly overshot on the hawkish side and we got a very ugly market close on Wednesday.
It is important to understand that this Fed process to bring inflation down is, by necessity, designed to take down asset prices (stocks, housing, etc.); slow the economy down; but at the same time not creating havoc in the process (i.e., coasting down the mountain). Thus far, it has been successful. The decline in markets has been orderly. Don’t be shocked if following this presser, various Fed members back off a little from the hawkish tone established by Powell on Wednesday. Remember, they are coasting down the mountain. On Wednesday, they tapped the brakes a little too hard, but nothing that can’t be corrected… So far, so good.
Our advice continues to be that the focus should be on economic activity, not on rates. In the long run, it makes little difference if the terminal rate is 0.25% higher or lower than is currently expected. What matters is whether the Fed can successfully coast to the bottom of the mountain. If they can do it without causing a crisis, we then have a pretty fair shot at maintaining ‘normal’ interest rates over the intermediate term. If they the path to the bottom of the mountain is crisis (aka, going over the cliff), then we are back to extreme low interest rate policy and a much bigger hole to dig out from later on. The economy is clearly getting weaker, albeit with a strong labor market. The risk is that Powell overplays his hand and he loses the economy on the downside.
Nowhere to hide
It’s no secret that we are ‘all-in’ on diversification, and most of the time, that works out pretty well. Not this year. This will go down in the history books as one of the most unpleasant for investors in a very long time. For some perspective, we took a look at the Vanguard Balanced Index Fund, which is essentially a 60/40 stock-bond fund (Sym: VBIAX). As of the end of October, VBIAX is down about 17.4%, while the S&P 500 ETF is down about 17.8% and the Aggregate Bond ETF (a proxy for the total bond market) is down about 15.5%. In short, there has been nowhere to run and nowhere to hide, all year long. Because stocks and bonds are generally uncorrelated, this is an unusual outcome, but obviously, it can, and does, happen. With two months to go in 2022, we expect the pain to continue for a little while longer, but the death of diversification has been greatly exaggerated.
With interest rates now at levels we would consider in the range of ‘normal’, we think stocks and bonds can return to their more normal relationship, once we have this recession out of the way. Bubbles drive asset prices higher and higher and the response to the pandemic was a doozey of a bubble. But that has now been pricked and the deflation of the bubble is underway. Stocks are not incredibly cheap yet, but they are no longer incredibly expensive either. The rise in rates has also made bonds a viable alternative to stocks for the first time in many years. The TINA period (there is no alternative) for stock investing is over and there are alternatives again. In our mind, the bond market is actually cheaper than the stock market right now. We just need the Fed to begin to step away from big rate increases and that was indeed the message this week.
But we are still coasting down the mountain and we expect more starts and stops and sharp turns to keep us just a bit uneasy. But at some point, we reach the bottom of the mountain and the Fed becomes less important and fundamentals and valuation become more important. We look forward to that time because that’s when things return to some semblance of normalcy. Can’t wait!
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