Fall, one of my favorite seasons, started this week. It’s a time when we could all start getting some reprieve from the recent heat wave. Unfortunately, it coincided with a market that continues to fall. It should not have been a surprise to anyone that follows the markets that the Federal Reserve would be meeting this week to raise interest rates. While there was some debate (especially after last week’s CPI print) on how much they would raise, 0.75% was surely in the bag. It wasn’t just our central bank that raised rates. Central banks in England, Japan, Switzerland, and Sweden met to discuss the surging inflation. With the exception of Japan, all central banks have followed our Fed by raising rates.
After the meeting our Fed’s board members updated their projections on what they think will be the future path of interest rates. In the Fed’s “dot plot,” each governor gives an estimate of where they think rates will be at the end of this year, next year, and in the longer term (see below). Surveys and estimates are always tricky, but since these are the actual officials that vote on interest rates, I would think their opinions weigh a little bit more than mine. I find it quite notable that the Fed thinks they’ll raise rates into next year but at a much slower pace. Of course, they’ll need to see better inflation data if that’s going to happen.
If the Fed continues on their predicted path and rates move to 4.0% – 4.25% by the end of this year, it will mark the most aggressive Fed tightening cycle since World War II. This steep rise in rates (plus the quantitative tapering that is just starting) continues to send shock waves through fixed income and equity markets – because of this, looking at historical analogs proves difficult. From a valuation standpoint, stocks and bonds look relatively cheap. Consequently though, when looking at interest rates and inflation trends, stocks and bonds look expensive. To make matters even harder, the market’s high concentration of the top-ten technology stocks is throwing off the averages. The valuation of the top-ten stocks in the S&P 500 is almost 70% higher than the other 490(1)!
We wrote in our article earlier this week the outlook for the economy and how markets continue to look foggy as the Fed continues their aggressive tightening. The one thing that is becoming more clear – America is heading into a recession (if we aren’t in one already). We continue to believe that a recession will likely be a modest one and should not turn into a global crisis like the Great Financial Crisis in 2007-09. For our long-term readers, you’ll know that our emphasis on higher-quality assets has been our theme for a while now. We continue to be underweight on the fixed income side and concentrate on high-quality, short-term bonds. We are cautious about chasing yield in lower-quality bonds. On the stock side, we continue to focus on high-quality businesses with durable competitive advantages and strong profitability. We think high-quality continues to be the best place to invest during times of craziness and even during a modest recession. We can still see declines of 20 – 30% in high-quality equities. However, we are confident that these businesses have lasting advantages and strong management that can trial what we’re going through.
While the Fed continues its aggressive tightening policies, we expect stocks and bonds to remain in a bear market. I can’t predict if we are closer to the end or the beginning of this tightening cycle; the inflation data over the next few months will dictate that. But this isn’t anything new. There have been over twelve bear markets since WWII. Bear markets are something that we tend to see every few years. They happen with so much frequency that we incorporate them into your Apriem financial plan. We stress test plans so they can withstand varied market conditions. While market conditions may take a while to sort themselves out, we realize that your individual financial situations may change at any moment. It is those situations that we need to consider for your plan for it to be an effective one. If you haven’t done a financial plan with us, please contact your Wealth Manager for one today.
Benjamin Lau, CFA
Chief Investment Officer