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March 28th, 2022
Author: SteelPeak Wealth – Institute of Portfolio Management
Stocks bounced back last week in the absence of further escalation in the Russia/Ukraine war. The S&P 500 rose 1.5% and the Nasdaq added 2%. The S&P 500 is now up 10% from the lows on the day of invasion and just 5% from its all-time high. Investor sentiment has been terrible for weeks, which often precedes a bounce in equity prices. Interest rates moved up sharply last week with the 10-year yield rising 35bps as Jay Powell reiterated his commitment to raising rates to curb inflation. The economic recovery following the pandemic lockdowns has been the most rapid in recent history. The Fed is having to playing catch up and is creating a rapidly evolving environment for investors to navigate.
Over the last two years, the unemployment rate has fallen 10%, from 14.7% to 3.8%. In the two years following the financial crisis, the unemployment rate fell just 1.4%, from 10% to 8.6% (see chart below).
We believe rapid improvement in the labor market can be attributed to both fiscal and monetary stimulus that was used during the pandemic. The direct payments to consumers provided much needed assistance to people who lost their jobs, however, the government was indiscriminate on who they sent money to. Unfortunately, there were instances where employees chose not to return to work because unemployment benefits paid more than their prior employer. As a result of all the economic stimulus, a rapid economic recovery and now rising wages, the US consumer has been flush with cash.
The chart below shows the amount of cash sitting in checking accounts in US banks. Prior to the pandemic, the peak in checking account deposits was $1.5 trillion. Today, there is slightly more than $4 trillion sitting in checking accounts. All that cash has enabled strong consumer spending but coupled with strained supply chains and economic sanctions on Russia, it appears to be causing the highest inflation in decades.
The Federal Reserve operates with a dual mandate from Congress to optimize employment and stabilize prices. During the pandemic, the unemployment rate was the highest since the Great Depression, so the Fed maintained a supportive policy stance to bring the unemployment rate down. Since the onset of the pandemic, the Fed’s policies have accelerated the economic recovery by enabling businesses to hire, the stock market to double, and the housing market to boom. While striving to achieve their goal of full employment, the Fed seems to have neglected its goal of containing inflation. With the cost of living now rising at an 8% annual rate, the Fed has quickly shifted its attention to combating inflation.
Earlier this month, the Fed raised rates by 0.25% in the first increase since 2018. The Fed also stated they expect to raise rates an additional six times before year-end. The futures market is quickly pricing in a more aggressive path of rate increases and currently is expecting the Fed Funds rate to be 2% higher by year end (2.25-2.5%). The Fed is trying the thread the needle by raising rates enough to bring down inflation, but not so much that they cause a recession and increases to unemployment. Historically, this has been a tough target to hit.
There have been three instances when the Fed has done this successfully; 1966, 1984, and 1995. The graph below shows the fed funds rate (black), the unemployment rate (blue), and recessions (red). In most cases, when the Fed raises rates quickly, they often push the economy into a recession. Since 1954, there have been nine recessions; all of them were preceded by the Fed raising rates. The three years mentioned above (green circles), were instances where the Fed successfully raised rates to fight inflation and avoided causing a recession.
In our view, the current environment requires investors to hold different views based on time horizon.
- In the short-term (three to six months), stocks are likely to do well given that stocks typically rise after the first interest rate hike by the Fed. Inflation is often good for earnings as companies can raise prices to offset rising input costs.
- Over the mid-term (two to three years), investors likely need to be prepared for a wider range of potential outcomes. If inflation moderates without the Fed having to raise rates to the point of causing a recession, financial markets can do quite well. Below are the forward returns for the S&P 500 following the three previously mentioned instances when the Fed paused their tightening cycle before causing a recession.
• Over the long term (five years or more), investors should be encouraged by the effectiveness of the Fed’s actions during the pandemic. When we do enter a recession, the Fed has the tools necessary to the economy. Additionally, the Fed has demonstrated their willingness to go to greater lengths to support the US economy and financial markets. In response to the pandemic, the Fed purchased trillions of dollars of securities, authorized nearly $3 trillion is lending facilities (Paycheck Protection Program, etc.), and pledged unlimited support for money market funds.
The Fed’s pivot from stimulating the economy and promoting job growth to tightening policy to control inflation is creating a challenging investment landscape. Investors should prepare themselves mentally for a slower ascent in stock prices and greater volatility as these are common attributes of Fed tightening cycles. The worst results come from emotional decisions that are made in response to unexpected events. A good way to defend against these outcomes is to manage expectation and expect the unexpected.
T I P O F T H E W E E K
Consider setting up ground rules before you take someone into your home like a roommate or even a family member. It may be uncomfortable, but no one wants to argue over misunderstandings.
THE WEEK AHEAD: KEY ECONOMIC DATA
Tuesday: Consumer Confidence. JOLTS (Job Openings and Turnover Survey).
Wednesday: Gross Domestic Product (GDP). Automated Data Processing (ADP) Employment Report.
Thursday: Jobless Claims.
Friday: Employment Situation. Institute for Supply Management (ISM) Manufacturing Index.
Source: Econoday, March 25, 2022
The Econoday economic calendar lists upcoming U.S. economic data releases (including key economic indicators), Federal Reserve policy meetings, and speaking engagements of Federal Reserve officials. The content is developed from sources believed to be providing accurate information. The forecasts or forward-looking statements are based on assumptions and may not materialize. The forecasts also are subject to revision.
THE WEEK AHEAD: COMPANIES REPORTING EARNINGS
Tuesday: Micron Technology, Inc. (MU), lululemon athletica, inc. (LULU), Chewy (CHWY).
Wednesday: Paychex, Inc. (PAYX).
Thursday: Walgreens Boots Alliance, Inc. (WBA).
Source: Zacks, March 25, 2022
Companies mentioned are for informational purposes only. It should not be considered a solicitation for the purchase or sale of the securities. Investing involves risks, and investment decisions should be based on your own goals, time horizon, and tolerance for risk. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. Companies may reschedule when they report earnings without notice.
Q U O T E O F T H E W E E K
“The battles that count aren’t the ones for gold medals. The struggles within yourself — the invisible, inevitable battles inside all of us — that’s where it’s at.”
T H E W E E K L Y R I D D L E
New furniture will be delivered to your office on the day before five days from the day after tomorrow. If today is August 18, when will the furniture arrive?
LAST WEEK’S RIDDLE: Two lawyers sit at opposite ends of a large conference table. Nothing is in between them but the table, yet they don’t see each other. How is this possible?
ANSWER: They are both sitting so that their backs are turned to each other.
SteelPeak Wealth –
Institute of Portfolio Management
For more financial news and resources, visit our Insights page ⇒