Current Outlook & Portfolio Strategy
Posted on October 28, 2022
The recurring narrative in U.S. equity markets this year has been ‘expect more volatility,’ and the third quarter showed markets continue to read from the same script. U.S. equity markets experienced a nice rally from the market lows in June only to give back some of those gains late in the quarter. Why? Market participants are coming to terms with stubbornly high price inflation and the U.S. Federal Reserve Board’s determination to dampen it through interest rate increases.
Market participants helped drive U.S. equity markets higher with expectations that the U.S. economy had already reached peak inflation and that the Fed would soon abandon its well-advertised policy to continue raising interest rates. In fact, some investors strongly believed that the Fed would soon start cutting interest rates to avoid a recession. Given that we have had a few months of declining inflation readings and positive economic reports, such views may have seemed warranted, but they may be slightly premature. The August Consumer Price Index (CPI) report showed a continued decline in headline inflation to 8.3% year-over-year, thanks largely to declining oil and fuel costs. However, the Fed is largely concerned with core inflation prices, which exclude the impacts of volatile food and energy costs. The same August report showed core CPI prices increased to 6.3% year-over-year, which broke the downward trend from prior months. This led to a sharp correction in equity markets late in the quarter and a lesson to market participants to remember the long-standing mantra: Don’t fight the Fed.
Fed governors returned from their August recess and demonstrated their continued resolve to reduce inflation. During their September meeting, the Fed raised short-term interest rates again by 0.75% and continued to remark that inflation will not decline organically yet. This decision brings their target range of short-term interest rates to 3.00% – 3.25%. After the meeting, Chairman Jerome Powell reiterated the Fed’s intention to continue raising interest rates based upon its assessment of monthly inflation reports and other economic data. Market participants immediately saw a greater likelihood of the Fed increasing rates too much, leading to a more severe economic downturn. Hence, the continued market volatility. A positive effect from these higher interest rates, however, is that bonds now appear more attractive than they have in years. A 1-Year U.S. Treasury Bill is yielding about 4%, which may appeal to investors seeking a short-term, risk-free investment, while a 10-Year Treasury is yielding about 3.5%. Yields this high have not been available since before the Great Financial Crisis of 2008-09.
Our outlook for the fourth quarter is to expect market volatility to continue. Investors will be monitoring the monthly economic reports (such as inflation readings and jobs growth) and quarterly company earnings reports as they seek answers to such questions as, “Will the Fed adjust its interest rate policy by ceasing rate increases?” and “Will company earnings decline as they face continued inflationary headwinds?” These data points can and do change month-to-month and quarter-to-quarter, so equity markets may fluctuate as the information is digested and acted upon. We remain confident that the U.S. economy will recover and persevere, but it may take time. For now, these volatile periods are best handled by understanding your near-term cash flow needs and ensuring those needs are met through an appropriate allocation to high-quality dividend stocks, short-term bonds, and cash. This will allow you to maintain an appropriate allocation to high-quality U.S. stocks (both growth and dividend stocks), which continue to look very attractive for patient, long-term investors.
Andrew Vanderhorst, CFA, CAIA, CFP®
Chief Investment Officer
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