The Fed’s fight against inflation has a way to go
Against a backdrop of continuing market volatility, investors might still find sufficient compensation for today’s market risks.
Our Top Market Takeaways for September 23, 2022
Market update: Expect more tightening
Aggressive policy tightening is the name of the game for global central banks. A handful of different central banks around the world moved their policy rates higher, but none caught more attention than the U.S. Federal Reserve.
The Federal Open Market Committee (FOMC) delivered its third consecutive 75-basis-point rate hike, bringing its target policy range to its highest level since 2008 (3%-3.25%). The size of the rate hike was widely expected, but the Fed’s updated economic projections jolted markets. They are now calling for below-trend economic growth over the next few years, a not-insignificant rise in the unemployment rate, and inflation to stay notably above their 2% target until at least 2024.
Their message was loud and clear: Conquering inflation is proving to be much harder than expected, and the pursuit of that goal is likely to come with some collateral damage.
Markets reacted in risk-off fashion. The 2-year Treasury yield climbed more than 25 basis points since last Friday and is at its highest level since 2007 (4.12%). The 10-year Treasury yield settled at a decade-high 3.71% after a 26-basis-point rise on the week, despite the added fuel to recession fear flames. S&P 500 stocks are down about 3%, with the index at its lowest level since the second half of June. The U.S. dollar hasn’t been this strong since the early 2000s.
Along with the rest of Wall Street, we hung onto Chair Jerome Powell’s every word at the press conference following the release of the decision and updated Summary of Economic Projections. Below, we take a stab at interpreting some of the key soundbites from what turned out to be the most hawkish Fed day that investors have seen in 40 years, and discuss the implications for investors.
Spotlight: What he said, and what we think he meant
What Powell said about inflation: “We are focused on getting inflation back down to 2%.”
What we think he meant: Inflation is much more stubborn than we expected, and the battle is far from over.
Markets adjusted their outlook for the Fed’s go-forward policy path after last week’s inflation data by pricing in a higher terminal rate (north of 4.5%) to be reached in the first half of 2023. Thereafter, the market’s consensus view is for cuts to come in the second half of 2023.
The Fed signaled that those expectations needed to be adjusted further. As shown by the dot plot, the median FOMC member thinks the Fed’s target policy rate range will still be 4.50%-4.75% by the end of next year, implying that the Fed doesn’t plan to deliver any rate cuts until 2024.
That seems to be a function of the upward revision in their expected inflation rate throughout this year and next: The median FOMC member thinks core Personal Consumption Expenditures (PCE) – their preferred inflation gauge – will still be running at 3.1% year-over-year by the end of 2023.
Two observations, if obvious ones: First, 3.1% is still uncomfortably higher than their 2% target. Second, they’ve been wrong on inflation for a long time now (join the party). Bottom line, the Fed wants to be clear that they think they have more work to do before inflation will come down satisfactorily.
What Powell said about economic growth: “I wish there were a painless way to [bring inflation back down to 2%]; there isn’t.”
What we think he meant: We’re probably going to have to break some stuff along the way.
This isn’t a new message, but that doesn’t make it any less hard to swallow. Powell stopped short of conceding that their mission can’t be accomplished without catalyzing a recession. That considered with eyes wide open, the unemployment rate expectations they published make it harder to believe they’ll still be able to land the plane.
The median FOMC member sees unemployment reaching 4.4% by year-end 2023 and holding steady there into 2024. Coming off the summer’s low of 3.5%, that’s not great, but it’s not wildly above the normal unemployment rates we saw before the Great Financial Crisis.
The problem, though, is that when you look at periods when the unemployment rate rose at least 0.5 percentage points over the past 50 years, it had a tendency to keep rising. On average, the increase was to the tune of around three percentage points. If we assume the size of the labor force stays the same as it is today, a rise in the unemployment rate to ~6.5% could mean over 4.5 million job losses. Context is important: We saw about 8.7 million job losses through the recession in 2008-09. We don’t think the “pain” Powell is warning of implies a crisis-like recession, but rather, a mild one.
What Powell said about their balance sheet: “We're not considering [selling assets on our balance sheet] and I don't expect that we will any time soon.”
What we think he meant: The policy rate is the primary tool in their toolkit.
Jumping back to the start of the summer, the Fed announced the start of Quantitative Tightening (QT), or the reduction in the size of its balance sheet, allowing for a capped amount of Treasuries and Agency Mortgage-Backed Securities to start maturing without reinvesting the proceeds. The process started with a monthly cap of close to $50 billion of securities and accelerated to a maximum pace of about $100 billion of securities per month in September.
As a base case, we expect QT to go until the end of 2024, at which point the Fed’s balance sheet will be back to the pre-COVID level of 25% of GDP (from ~36% currently) or thereabouts. With the Fed reducing its Treasury holdings, that leaves markets to digest the additional issuance from the Treasury, a potential upside risk for Treasury yields and overall risk sentiment. For equities, we think much of the volatility related to poor liquidity is behind us, and the focus will return to economic growth and the corporate earnings outlook.
While QT is certainly a risk for markets, we think the primary focus for investors should be on the macro and policy rate outlook. We think Powell would echo that sentiment, acknowledging that as their balance sheet shrinks, their attention will be on the level of the Federal Funds rate that is sufficient enough to slow growth and put a lid on inflation.
Investment implications: Strengthen your core
There wasn’t anything cheerful about the Fed’s messaging this week, and it’s likely to perpetuate the market volatility and sour sentiment we’ve been muddling through in 2022. If we may add just a glimmer of optimism, there’s still a chance price pressures fade more quickly than the Fed is now expecting.
Nonetheless, there’s a reason why the mantra of, “Don’t fight the Fed” has had so much staying power, and it may feel daunting to maintain risk exposure in an environment characterized by pervasive uncertainty and high risk-free rates.
So, what can investors do about it? For starters, the most crucial consideration for your portfolio is the status of your own personal risk tolerance and long-term goals.
From there, we continue to prioritize our focus on adding to core fixed income. The asset class has been beaten up this year due to the rapid rise in rates, but that in turn has created a compelling entry point. Elevated uncertainty and risk of recession call for this kind of portfolio buffer, with the added bonus of the potential for “equity-like” returns.
While we aren’t yet ready to say that large cap stocks have priced in enough pain to make them an obvious buying opportunity, their valuations are getting closer to the point where we would be more inclined to add exposure. Mid-cap valuations, on the other hand, seem to be reflecting more than enough risk to make the potential compensation worthwhile. We also see opportunities in segments of the market where capital is scarce, such as private credit, mezzanine debt and preferred equity.
Remember that volatility is a feature of investing, and that markets have bad months, quarters and years. Still, historical evidence supports the argument that having exposure to them is an effective way to build wealth over time. Reach out to your J.P. Morgan representative to check up on your plan and discuss what actions may make the most sense for your particular situation.
All market and economic data as of September 23, 2022 and sourced from Bloomberg and FactSet unless otherwise stated.
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