Rate Cycle Sea Change Underway
We are entering a transitional phase in the markets. As the old adage goes, “Don’t fight the Fed”. That adage has applied over the past several years as the Federal Reserve stimulated the economy, and will apply in the reverse under the new cycle of rising interest rates; as the Fed removes liquidity from the system, there simply will be less money available to buy assets, including stocks.
While the major indices rallied over the final month of the first quarter, we believe the increased market volatility is likely to continue. In the early months of 2022, equity markets saw a sharp correction followed by an equally sharp rally to recover some of the losses. The S&P 500 finished down 4.6% for the quarter ending March 31st. More surprising was that fixed income was down even more, nearly 6%, as yields rose steadily and drove bond prices significantly lower. The list of headwinds facing investors in 2022 includes:
- The Federal Reserve raising short term interest rates and reducing purchase of Treasury securities (balance sheet reduction) as a means to fight inflation, resulting in a higher cost of financing across the economy and pressuring bond prices
- Inflation itself, including the impact of rising food, energy, and housing prices
- Increasing fear of recession impacting consumer sentiment and willingness to spend
- Deceleration of corporate earnings growth pressuring stock prices
It’s no wonder that consumer and investor sentiment has recently hit lows only seen in the 2008-2009 financial crisis. When investors feel gloomy and worried about the outlook, their natural tendency is to sell risk assets, particularly stocks because of their liquidity. The good news is that bearish consumer sentiment has been a consistent contrarian indicator. On average, buying stocks at peak confidence levels has yielded an average 12-month return of 4.4%, while buying at the trough has returned 24.5%. While our expectation is not that U.S. stocks will return anything like 24.5% in the year ahead, it does suggest that planning for 2022 and beyond, investors should focus on what they own, why they own it, and whether it is over or under-valued at current prices, rather than how they feel about the world today.
Inflation is our top concern, with labor, energy, materials, and finished goods prices remaining elevated, well above the Federal Reserve target of 2%. An aging baby boom generation, COVID-reduced work force, and limited immigration will continue to limit labor force growth, likely leading to chronic excess demand for labor and strong wage gains, thus helping sustain inflation. Additionally, over the past two years, the pandemic-induced monetary and fiscal stimulus created a supply/demand imbalance in goods and services of all types. Fiscal policies ensured that businesses and consumers had the capital to continue spending, but there was a sudden shift in demand away from services and into goods because of the pandemic, which the global economy was not prepared to handle. Supply chains were upended, leading to a shortage of goods and rising prices. Supply chains continue to be further challenged with China’s Zero-COVID tolerance policy leading to widespread lockdowns and factory closures. The impact includes a scarcity of raw materials and components like semiconductors, with reduced factory output facing auto manufacturers, among others, as they struggle to procure the necessary inputs.
Consumer spending on services, particularly in the leisure, travel, and entertainment sectors, continues to recover as evidenced by rising TSA screenings, hotel occupancy rates, and restaurant reservations. This recovery will add additional momentum to the economy over the spring and summer of 2022. Thereafter, growth should slow as the economy reaches capacity limits due to the shortage of workers, while fiscal and monetary policy become even more restrictive.
So, we believe investors are currently faced with a most important question: Can the Federal Reserve get control of inflation without inducing a recession? Said another way, can the Fed raise the price of money without destroying the demand for labor, goods, and services, which is the lifeblood of the economy? The Fed will continue to tighten aggressively “until something breaks”, either inflation or the labor market. The hope, of course, is that inflation will break first, as you cannot have a recession without falling employment.
Today the unemployment rate is approaching 3.4%, the lowest rate since 1953. The 11 million US job openings far exceed the current number of unemployed workers. As long as employment remains strong, the Fed has the mandate to focus on inflation, while the risk of recession remains somewhat muted.
Looking forward, we are executing on our long term investment process by focusing our attention on asset allocation and diversification. Historically low nominal interest rates, negative real rates, and an inflationary environment still favor stocks over bonds, but the nature of “the TINA trade” (There Is No Alternative to stocks) is evolving. For the past several years, perpetually low rates meant that most stocks, regardless of valuation or growth prospects, were a better alternative to bonds for investors seeking higher returns. However, with rates now rising, a more selective group of equities will outperform. We remain focused on security valuations and company fundamentals. As such, client portfolios remain overweight to U.S. large capitalization equities targeted toward enterprises with attractive profit margins, cash flow, and revenue and earnings growth. We continue to be significantly underweight traditional fixed income in favor of non-traditional strategies, private investments, and other income producing assets.
As always, reach out to us with your questions or concerns.
Atlantic Union Bank Wealth Management is a division of Atlantic Union Bank that offers asset management, private banking, and trust and estate services. Securities are not insured by the FDIC or any other government agency, are not deposits or obligations of Atlantic Union Bank, are not guaranteed by Atlantic Union Bank or any of its affiliates, and are subject to risks, including the possible loss of principal. Deposit products are provided by Atlantic Union Bank, Member FDIC.
Past performance quoted is past performance and is not a guarantee of future results. Portfolio diversification does not guarantee investment returns and does not eliminate the risk of loss. The opinions and estimates put forth constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.