Fed Governor Lael Brainard warned us on Tuesday. Former Fed President Bill Dudley’s Op-ed followed on Wednesday, noting “One thing is certain, to be effective, it’ll (the Fed) have to inflict more losses on stock and bond investors than it has so far.” Meeting minutes released from the Fed on Wednesday afternoon confirmed what both were hinting at, that the Fed is pulling out all their tools to fight inflation. Yes, this is partially their fault since they kept expanding the balance sheet up through February, but they have turned 180 degrees.
A 50bps increase in Fed Funds is all but guaranteed at the next meeting in May. On top of that, balance sheet normalization will also commence, with upwards of $60B in Treasuries and $35B in mortgage-backed securities being allowed to roll-off. Basically, no more reinvesting bonds that mature on their balance sheet. Over the next 12 months, there are nearly $1T in bonds that will expire, pretty much in line with the caps offered. Once this process gets rolling, the Fed will “discuss” active sales as well. Recall, last year the Fed was still purchasing $120B in bonds on a monthly basis, but they are quickly reversing course.
As you might expect, stocks and bonds took notice and continued their declines into yesterday before staging a sizable rebound in the final hours. Major averages dropped hard on Tuesday and Wednesday with the Nasdaq’s 5% loss leading the way. Technology, Financials and Consumer Discretionary stocks dropped, while the defensive havens of Utilities, Consumer Staples and Healthcare held up fairly well. Needless to say, this is not bull market action. After seeing new lows in numerous stocks, dip-buyers swooped in, helping create a 500+ point positive swing in the Dow Jones to close out Thursday in positive territory.
Major averages have now traded within a 20% range for over a year. On the S&P, that equates to 4,000 on the low end and 4,800 on the top. When the future is as uncertain as it is today, this is what happens. The Fed usually raises rates when stock market volatility is low, as opposed to today. Also, we’ve never seen sizable rate hikes paired with an aggressive balance sheet decline. Federal Reserve actions could point to some of the more negative outcomes occurring. There are no historical occurrences to reference. We are in unchartered waters. Stocks and bonds move on earnings expectations, but also on the range of possible outcomes as well.
A wider range of future outcomes directly leads to wider swings in stocks and bonds. Even oil is seeing 10% moves on a bi-weekly basis lately. There are plenty of possible outcomes, but let me break them into 4 buckets and consider them each having a 25% chance of occurring over the next 12-18 months:
1. The Fed is aggressive enough early on, supply chains keep improving, demand slows but doesn’t collapse, interest rates on the long end peak shortly, mortgage activity gets back to trend, more unemployed workers come back and Russian sanctions are eased. Consumers are still flush with cash and inflation gets back to 3% or lower by year end. This is the bullish theme. Stocks can do well in this outcome.
2. The Fed is too aggressive, causing an inverted yield curve, housing demand collapses, consumers pull back spending, inflation comes down but is more tied to demand destruction, corporate margins get squeezed, unemployment rises, GDP declines in 2023, Russian sanctions get worse. This is the bearish theme and coincides with previous yield curve inversions that preceded a recession. Obviously, not great for stocks.
3. The Fed is too late to the party, inflation is imbedded in our economy and still over 5% at year’s end. Aggressive Fed actions bring higher interest rates, but only a minor or no recession. Gas prices remain over $5 at the pump. Food prices keep rising due to the Russia/Ukraine supply chain mess. Consumers use up their savings and have little excess discretionary monies to spend. GDP comes down but is still barely positive. This is the stagflation scenario, not great for stocks or bonds.
4. The Fed talks tough but doesn’t need to follow through with 10+ rate increases or reduce its balance sheet aggressively past December. Inflation comes down naturally via slowing demand and a dramatic improvement in supplies. Covid is over. Russia and Ukraine come to a peaceful agreement. Interest rates stay near current levels. This would also be a bullish outcome.
There are a million other, more detailed scenarios, but the point remains. The range of outcomes is as wide as investors can recall for years, especially with critical factors like interest rates, inflation, job growth, geopolitics and earnings. This directly leads to more volatility in stocks and bonds, a wide trading range and confusion for day-to-day market watchers. Investors can either ride out this wave or try to time tops and bottoms.
For most of our readers and clients, we focus on the long-term. Yes, owning a utility for a few months that has a 3% dividend yield may be better than something more economically sensitive like Alphabet (Google)#. However, there are consequences to making such near-sighted moves. First and foremost are taxes for non-sheltered accounts. Anyone holding Google today probably has a huge gain from years of solid growth. Uncle Sam takes his 20%+ from realized gains on taxable sales. One would need to see Google# drop upwards of 20% in order to have that sale make sense on an after-tax basis. Ask yourself, would you want to buy Google 20% lower? The long-term answer is probably yes.
Now take fundamentals into play. Utilities typically grow their earnings 3% – 6% annually at best. Currently, they are trading at one of their highest P/E levels ever, with many over 22x 2022 estimates. On the other hand, Google# trades at 20x next year’s estimates which are growing at 17%. What is the better long-term play? Day traders can play this short-term game and some do it with relative success. We don’t recommend that for “long-term growth at a reasonable price” investors. Put a price chart of Google# vs. Dominion Energy# and see the wealth accumulated over time. There is more volatility, but growth in earnings wins out at the end.
However, that does not mean that risk measures shouldn’t be put in place. As noted above, when the range of outcomes is as wide as ever, it behooves one to lock in some gains on lower-quality stocks, raise a little bit of cash that can be redeployed when the clouds dissipate and maintain exposure to favored winners such as Google#. Numerous stocks may have already seen their bottoms in March. We could always retest those levels and redeploy cash while focusing on the 5-year horizon. Things will improve.
We can ride out a range-bound market with a high-quality portfolio. Eventually that wide band of outcomes becomes smaller. Ideally, this starts with easier conditions in fixed income, as opposed to spiking interest rates across the curve. After briefly inverting, the 10/2 yield curve is back to a normalized positive slope by 20bps. That could be a sign that Fed actions will work and some of the more negative outcomes can be taken off the table. When holding world class companies trading at fair valuations, we can play the waiting game before making drastic decisions. Futures are tacking onto yesterday’s late rally. Is all of the Fed action finally priced in?
Actresses Robin Wright and Patricia Arquette turn 56 and 54 today.
James Vogt, 610-260-2214