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As the summer winds down, we find that what we discussed in our July commentary is coming to pass. Last week, Federal Reserve Chair Jerome Powell said a few things at the Jackson Hole Economic Symposium that many thought were “on script” yet his remarks were somehow perceived as shocking, causing yet another bout of downward market volatility. The narrative from the Fed is likely to remain “hawkish,” in an effort to maintain their inflation-fighting credibility. Mr. Powell delivered forcefully on that front, notably:
Interest rates: “…another unusually large increase in the Federal funds rate could be appropriate at our next meeting.”
Translation: Expect another increase of 75 basis points (+0.75%) in the Fed’s key interest rate on Sept. 21, taking it to a range of 3% – 3.25%.
Inflation: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.”
Translation: Because they cannot control supply, the Fed will continue to push down demand and hope a recession will not materialize.
Jobs: “The labor market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers.”
Translation: Unemployment is low and the Fed appears very comfortable with workers being laid off as fighting inflation may result in some economic pain.
What can we surmise from Chair Powell’s remarks? The Fed is focused on bringing down demand for U.S. goods, U.S. services, and U.S. workers, and this is happening at a time when inflation data, while albeit high, has been decelerating and evidence of slowing growth (or perhaps recession) is becoming more apparent.
The markets have already started doing a lot of the Fed’s work to tighten credit and slow the economy and were even prior to the first rate hike in March. Consider that over the past year or so, the yield on the 10-year Treasury has doubled, the yield on the 2-year has quadrupled, and the yield on the 1-year is up 40 times from where it was a year ago.
What the Fed is not saying (and I would prefer Chair Powell emphasize this) is that interest rate increases manifest themselves in the U.S. economy with a significant lag. The economic impact of this year’s rapid, significant rate hikes will likely not be apparent until March 2023 (12 months after the first rate increase) or even later since the first hike was only 25 basis points. The effects we are witnessing today are likely a result of what the markets have done all by themselves.
Ultimately, data releases on inflation and other key economic indicators in the coming weeks and months will be critically important in providing some clarity on the economic front. We maintain our position that a Fed policy error poses one of the greatest downside risks to the markets and economy, especially as we head into increased quantitative tightening and corporate earnings estimates likely continuing to trend downward.
What does this mean for client portfolios? The low volatility regime present prior to this year is no longer with us, despite bouts of occasional calm. Uncertainty regarding the speed and magnitude of future rate interest hikes vs. material signs of slowing growth and inflationary pressures should keep markets turbulent. Thankfully, our portfolios are designed intentionally to withstand volatility without impacting our clients’ lifestyle and other goals. Elevated market uncertainty and volatility are likely to continue to create dislocations of asset pricing versus fundamental value and, therefore, opportunities to add value to portfolios. Additionally, we continue to engage in things we know add value during market volatility, such as tax-loss harvesting and disciplined rebalancing.
We are also exploring new ideas and opportunities that can take advantage of the new market regime as well as longer-term trends, including credit (U.S. and/or European), infrastructure equities, onshoring and near-shoring trends, secondary offerings, and community bank buyouts to name a few.
Thank you for the trust you place in us. I will continue to reach out as market events warrant and hope you know that you can reach out to us any time with questions and concerns.
All my best,
Ronald G. Albahary, CFA®
Chief Investment Officer, Laird Norton Wealth Management