Fresh losses in the stock and bond markets after this week’s Federal Reserve meeting make one thing clear to investors: be prepared for more turbulence ahead.
The central bank this week raised the federal funds rate by 0.75% for the unprecedented third consecutive meeting, raising the target rate to 3.0% to 3.25%. At the same time, Fed officials have indicated that they expect continued interest rate increases that could raise this key short-term rate to 4.6% next year.
Plus, while it can sometimes be difficult for investors to interpret what Fed officials mean, the message was clear when Chairman Jerome Powell spoke following the decision to raise interest rates again aggressively: The Fed will do what it takes to bring inflation down from the 40-year highs . Doing so would mean a slowdown in the economy.
We have to keep inflation behind us. “I wish there was a painless way to do it, there is no other way,” Powell said. That pain includes higher rates, slower growth and a weaker job market, he said.
And although Powell did not say it directly, it is increasingly expected to include a recession, not just a so-called soft landing where the economy cools down but does not contract.
“As an investor, it’s not easy to hear this message,” says Chris Constantinos, chief investment analyst at Riverfront Investment Group.
Here are six tips for investors:
Prices will continue to rise
The clearest thing to take away from the Fed meeting is that short-term interest rates will continue to rise, and they will keep raising rates until officials are comfortable with the idea that inflation has already crossed the corner and is heading lower.
“The Fed has been surprisingly clear about which direction to take,” says Jason Trenert, chief investment analyst at Strategas Research Partners. While the Fed officially has a dual mandate of maximum sustainable job creation and stable prices, “for all intents and purposes, the Fed has only one mandate right now and that is price stability.”
Currently, the Fed forecasts that the fed funds rate will rise by another percentage point by the end of the year, an exceptionally fast pace of rate increases by historical standards.
To some extent, the fact that the economy has remained healthy as it was – especially the labor market–It may mean that the Fed will feel more comfortable staying on the path of raising interest rates. Plus, the fact that prices have been raised as much as it means that when it’s time to cut prices, there’s also plenty of room to bring them down, says Matt Freund, head of fixed income strategies and co-head of investment. Officer at Calamos Investments.
“The Fed generally thinks it has room to tighten without doing lasting damage,” he says. Freund adds that he thinks the Fed will be able to slow the rate hike as we move into next year.
Recession seems more likely
It is not only Powell’s comments that made market watchers look for a more meaningful economic slowdown. Warning signs in markets and the economy are increasingly flashing yellow about the possibility of an economic downturn. (Technically, GDP growth has already been negative for two quarters, which is generally seen as a stagnation.)
In the bond market, short-term interest rates are now higher than long-term interest rates, otherwise known as an inverted yield curve, and historically it is a strong indicator that a recession is approaching.
Following the Fed meeting, RiverFront’s Konstantinos said, “We’ve seen more reversal, which indicates that the potential for a hard landing is increasing.”
In the real economy, data accumulates in which the slowdown is growing. Richard Weiss, chief investment officer for multi-asset strategies at American Century Investments, notes that manufacturing surveys point almost uniformly to contraction, and now evidence of a slowdown in the housing market is mounting.
“It’s now clear that this thing isn’t going to get better in the near term, it’s just getting worse,” he says.
Keep an eye on earnings forecasts
While fears of a recession have been mounting for months, the stock market has been buoyed by continued strong corporate earnings. The question is at what point profits will roll over and turn negative.
“People have been lowering their expectations of earnings growth,” says Strategas’ Trenert, but they haven’t factored in the downturn yet. “We’ve never had a recession without a drop in profits.” He says that in an average recession, profits fall 30% and the average decline is 22%.
The tricky side of this for investors is that within weeks, third-quarter corporate earnings will appear. However, it will largely reflect an economy with continued strong consumer spending and a strong labor market, albeit as the inflation crisis continues.
This will likely mean a greater-than-usual focus on what companies have to say about expectations. Weiss says investors should be prepared for bad news.
“I think we’ll see a lot of talk in the C Suite about layoffs and forward (earnings) guidance to become more pessimistic,” he says. “If we were to get together in three to six months and place a gentleman’s bet, I think the profits would be negative in front of them.”
The caveat is that inflation raises corporate profits in nominal terms and could offset some of the downward pressure from the economic slowdown. “It’s not a done deal that profits will collapse even if the economy slows,” says RiverFront’s Konstantinos.
Uncertainty means volatility
The stock market has already been volatile this year thanks to the ripples of Fed rate hikes and uncertainty about the inflation outlook and policy response.
After the Fed meeting, Konstantinos said investors should be prepared for the constant swings back and forth in the stock market.
“I think the market will be range-bound and highly volatile for the next couple of months,” he says. While this could lead to more rallies like the ones we saw this summer, “the stock market will struggle to make higher progress.”
In this environment, Trenert suggests that investors should remember the market’s tendency to stage very strong rises in a bear market but remain in a downtrend. During the collapse of the dot.com bubble from 2000 through 2002, there were eight significant rallies, he says. “The last uptick was 44%, and then the market went down for another year,” Trenert says.
“This is going to be very difficult for the market,” he says.
Forget the “V” bounce command.
During the pandemic-driven bear market, equity investors were essentially being bailed out by the Fed’s very aggressive efforts to prop up the economy through the financial markets. A quick bounce in the markets is often referred to as a “V-shaped” recovery due to how it looks on the chart.
“This is not a cold-hit economy and we have a V-shaped recovery,” says Weiss of American Century. This is an unfamiliar area for many investors. “A lot of investors joined the markets after the 2008 financial crisis and only saw a V-shaped recovery” in the markets, he says.
Traders often refer to the “Fed Reserve Mode” which takes a term from the options market to say that the Fed will come to the bottom and effectively buy financial assets.
But with the Fed in a tight tightening position, “there is no Fed,” Trenert says. “People have been so conditioned that everything is V-shaped, but most of the time it doesn’t.”
You will pay to stay defensive
Against this background, investors should prepare for challenging markets.
“We’re cautious,” says Konstantinos of RiverFront. In general, they are neutral to slightly lower weights of stocks, but they focus more on generating a return on the portfolio in the current market environment. He points to the difficult stock market of the 1970s, as an example of how to position himself. “A lot of your returns in the market came from dividend yields.”
At Strategas, Trenert says they favor traditional defensive sectors like healthcare and basic consumer goods, but also, energy stocks unique to this economic cycle. “Usually you want to be out of energy stocks in a recession, because when the economy is down, energy prices go down,” he says. However, with the shift toward clean energy limiting energy companies’ desire to pump more oil despite higher prices, that should limit stagnation in lower oil prices, says Trenert. “We have a feeling that the energy companies will distribute a lot of cash to shareholders and dividend yields will remain strong.”
American Century’s Vice says his team has been defensive since the start of the year, prioritizing value over growth, along with defensive stocks. “We’re staying there,” he says. “It will be harsh.”
Correction (September 23): An earlier version of this story misspelled the name of Richard Weiss, chief investment officer for multi-asset strategies at American Century Investments.
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