After dropping borrowing rates to zero during the pandemic, the Federal Reserve has dramatically changed course in a bid to fight inflation. As we’ve written about before, higher rates have two key effects: a psychological one – weighing on risk appetite – and a mathematical one, as higher rates reduce the value of future cash flows from financial assets. Thus, with the federal funds rate widely predicted to hit 4.5% or higher in 2023 (increasing at a pace not seen in four decades), the market is understandably nervous. But, as we will explain, there are reasons for optimism, particularly for those of us who bemoaned the peak valuations of last year and longed for a day when we could buy high-quality assets at better prices.
Fed officials speak today with a rare, unified hawkishness that has many wondering if the Fed put, whereby the central bank rescues a market from a severe downturn, is still alive. Even the administration appears unconcerned over the hurtful growth consequences of the Fed’s policies – an unusual sight. And to be sure, U.S. investors are not the only ones alarmed as the Fed’s rate decisions have widely felt consequences beyond our borders. That's because the U.S. dollar remains the world's reserve currency. With much-improved yields and representing a safe haven amid uncertainty, the U.S. dollar looks ever more attractive, igniting a collapse this year in hard currencies like the British sterling, Euro, Japanese yen, and Chinese yuan. The result in all of those regions is inflationary pressure, increasing trade deficits, and higher interest rates.
In important ways, the reversal of stimulative conditions we’re witnessing has precedent. During WWI, WWII, and the Vietnam conflict, the government directed the allocation of resources and dominated gross domestic product (GDP), stoking high inflation. It then had the unenviable task of dismantling a command economy without causing too much pain to the average household. Although the transition was uncomfortable, those inflationary fires eventually subsided, paving the way for a period of outsized prosperity despite the pessimism of many economists.
Will the Fed change course before too much damage has been wrought? It clearly hasn’t been enough that the value of risk assets like stocks, real estate, commodities, and cryptocurrencies have declined precipitously. Some hold the view that the Federal Reserve may continue to raise rates until something breaks. What a strange thing to hope for! Perhaps reflecting some wishful thinking, the recent interventions by the Bank of England and Bank of Japan to save their respective currencies could be construed as a policy stance taken too far. We would also note that in ways that could go to some lengths to placate central bankers, there are signs that U.S. inflation is moderating (e.g., lower freight and energy costs; decelerating rent growth), a trend further supported by a strong U.S. dollar, which enables businesses and households to purchase foreign goods more cheaply.
Although it may not feel like there is much to cheer, long-term investors should be getting excited. The nature of markets is that prices move above and below actual fundamentals. Looking back to the beginning of 2022, market prices had generally overshot reality, unaligned with economic and business conditions as well as historical norms. Today, conditions are such that many high-quality stocks are trading below fair value. Said another way, our ability to meet our clients’ long-term goals has vastly improved. Our view stands even if a recession takes hold next year, which would not surprise us. Firstly, recessions are a normal – and even healthy – part of the economic cycle. Secondly, we believe stocks are already pricing in some risk to near-term earnings whereas we are far more concerned with companies’ long-term earnings power. A silver lining to higher rates is that if the Fed stays resolute with its tight policies, the yields on high-quality municipal and corporate bonds may move higher, offering a nice premium to U.S. Treasury and agency securities that we can lock our clients into for a multi-year horizon.
Time and time again markets bring new challenges that confound even the most steadfast investors. The pandemic – and its aftermath – have no doubt surprised investors at many turns. And here is when we would counsel our clients that a long-term investment plan has the most value when our emotions get away from us. That is, we would be wise not to base decisions that will have a lasting impact on present conditions that will come to pass.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.