Federal Reserve Uprising

October 3, 2022

By Mark Oelschlager, CFA

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In 1987, Sports Illustrated, the preeminent sports periodical of the time, predicted the Cleveland Indians would win the American League pennant in its baseball season preview.  Two of the Indians players adorned the magazine’s cover – and making the cover of SI was a big deal – accompanied by the headline, "Indian Uprising."  The team went on to post the worst record in the major leagues that season.

 

This year the Cleveland franchise changed its name to "Guardians," and, with a younger average age than all other 29 teams and one of the lowest payrolls in the game, it generated little excitement heading into the season.  But throughout the summer, the Guards played solid baseball, often threatening to take control of the division but then falling back.  The fans, media, and handicappers were slow to believe.  In August the team caught fire, and after a brief losing streak, their hot play continued in September.  This group of youngsters, which took a while to catch people’s attention, left their competitors in the dust and clinched the division with 10 games left.  When the playoffs begin, they will look to win the franchise’s first World Series title since 1948.

 

Like the team formerly known as the Indians, the Federal Reserve (Fed) this year has struggled to be taken seriously, despite its many smoke signals to the markets.  For years the market could count on the Fed erring on the side of dovishness – keeping interest rates low or quickly cutting them in the event of market turmoil or economic weakness.  But circumstances have dramatically changed.  Inflation is no longer benign; in fact, it’s at a 40-year high.  As a result, Fed chief Powell and his tribe on the Federal Open Market Committee have repeatedly expressed their intention to raise rates enough to bring down inflation.  But the market was slow to believe, having been conditioned by a long period of loose monetary policy.  After a rough second quarter, stocks rallied about 14% in the first half of Q3, as a narrative developed that slowing growth in consumer prices, led by declining gas prices, would prompt the Fed to pivot from its hawkish stance.  The problem is that prices didn’t cooperate; they remained stubbornly high.  When this became clear, and Powell gave his testimony at the annual Jackson Hole event in late August, the market executed its own pivot, sending stocks back down to the lows of the year.  The market appears to finally believe.

 

This left stocks down for the quarter, with the S&P 500 off about 5%, while bonds haven’t fared any better as interest rates have skyrocketed.  The Bloomberg aggregate bond index was down about 5% in the quarter, while a highly traded basket of Treasury Bonds with maturities of over 20 years declined about 10%.  Since early December last year, this basket of long-term Treasurys has lost about 1/3 of its value.  That’s not a typo.  We have warned many times about the downside risk in supposedly “safe” bonds.  Unfortunately, as interest rates have climbed, that downside is now being better appreciated by those who thought bonds were riskless.

 

Most of the damage in the bond market has been due to interest rate risk (rising rates), rather than credit risk (risk of not being paid back).  If the economic outlook continues to worsen, corporate bonds, which are already down 19% since last November because of rising rates, could fall even further.

 

In our second quarter commentary we noted the rise in the 2-year Treasury yield to over 3%.  In September it eclipsed 4%, reaching levels it hadn’t seen in 15 years.  It is hard to believe that the 2-year yield sat at 1/4 of 1% just one year ago.  Long-term Treasury rates have also spiked, as have mortgage rates.  Given the decline in affordability, we expect the housing market to experience some softness in the coming quarters, though not to the degree we saw in the 2008 financial crisis.

 

One reason we spend so much time talking about the Fed, interest rates, and bond yields is that they are so important to the fate of stocks.  Falling rates are a tailwind for stocks (as was demonstrated in the 2010s), and rising rates are a headwind (as is being demonstrated now).  Rising interest rates negatively affect stocks in at least three ways.  They increase borrowing costs for corporations, they reduce the present value of all the future cash (profits) the company will generate (and this is essentially what a stock price represents), and they make alternative investments (such as bonds) more attractive.  They also raise the risk of recession, which is bad for stocks.  There is a reason "Don’t Fight the Fed" is a well-respected mantra on Wall Street.

 

The near-term picture is bleak, and as such it’s important to remind yourself why you invest in the first place: to have more money at a date far in the future.  Any funds that are needed six months from now should not be invested in stocks.  But for funds that will be needed far down the road, stocks are likely to provide the best return, given their historical record.

 

We don’t know how things are going to play out over the next year.  We believe there are reasons to remain cautious:

• Inflation may be hard to bring down.

• Many of the conditions that precede financial crises are in place now.

• Despite having declined, valuations are not yet compelling.

 

But there are also reasons to not make a full-on defensive shift:

• Inflation could decelerate.

• Some argue the economy is less interest rate-sensitive than in the past and will therefore muddle through this rate-hike cycle without a major economic downturn.  This feels a bit too much like the always dangerous "it’s different this time," but there is some truth to the premise.

• Investor sentiment, at least as indicated by surveys, is extremely bearish, which is usually what we see near market bottoms.

 

Another item that fits with the sentiment point is the general attitude toward cash.  A year ago, the phrase "cash is trash" was popular, as was its cousin TINA - There Is No Alternative (to stocks, given extremely low interest rates at the time).  As it turns out, relative to the alternatives, cash has not been trash, but a superior investment over that time period.  Today, nobody is saying "cash is trash."  Instead, it’s "cash is king."  Perhaps market participants have it wrong again, and stocks are about to outperform cash, though it certainly helps the prospects of cash that money-market yields are much higher than before.

 

Bear markets always alter the way some money managers are viewed, and this one is no different.  Some managers perform very differently (poorly) when conditions change.  That’s why we believe a manager should always be evaluated through a full economic cycle.  A manager might excel when the economy is strong, or when a particular type of stock is leading, or when certain monetary conditions exist, but he or she may struggle so much in other settings that on an overall basis the portfolio trails the benchmark or peers.

 

Investors are often reluctant to change their money manager, for various reasons.  Inertia is a powerful force, and many are particularly reticent to make a switch when the market is down.  (A common thought process: when things are going well, why change now; when things are going poorly, I can’t change now – things might bounce back!  The result is that the client never leaves the underperforming manager.)  Paradoxically, however, we would argue that if one is indeed considering a change, it makes even more sense to do so when stocks are down, for a non-retirement (taxable) account.  When an investor changes managers, the new manager will typically sell many of the stocks in the portfolio and replace them with ones that he or she believes have better prospects.  If these trades are executed when the market is down, the capital gains are less (or perhaps there are losses), which means the investor’s tax liability is less.  The effect is the same for an investor who sells one mutual fund and moves to another.

 

We manage our portfolios in a way that respects the potential for change.  In fact, we regularly try to find opportunities in stocks that would be positively impacted by potential change.  Oftentimes, the market prices securities as if prevailing conditions will be in place for a long time, but history shows that change is normal.  Understanding this helps us not only find attractive investments but avoid potentially damaging ones as well.

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Mark Oelschlager, CFA  

Oelschlager Investments 

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