The new losses in the equity and bond markets following this week’s Federal Reserve meeting make one thing clear for investors: be prepared for more turmoil to come.
The central bank raised the federal funds rate by 0.75% this week for an unprecedented third consecutive meeting, taking the funds rate target from 3.0% to 3.25%. At the same time, Fed officials have indicated that they expect continued rate hikes that could bring this key short-term rate to 4.6% next year.
Also, while it can sometimes be difficult for investors to interpret the meaning of Fed officials, the message was clear when President Jerome Powell spoke following the decision to aggressively raise interest rates again: The Fed will do everything needed to bring inflation down from 40 – year highs. And doing so will slow the economy down.
“We need to raise inflation. I wish there was a painless way to do it, there isn’t, “Powell said. That pain, he said, includes higher rates, slower growth, and a weaker job market.
And even if Powell didn’t say it directly, this is increasingly expected to include a recession, not just a so-called soft landing where the economy cools but doesn’t shrink.
“As an investor, that’s not an easy message to hear,” said Chris Konstantinos, chief investment strategist at RiverFront Investment Group.
Here are six tips for investors:
Rates will continue to rise
The most obvious point from the Fed meeting is that short-term interest rates will continue to rise and continue to raise rates until officials are comfortable with the idea that inflation has really turned the corner. and it’s heading to the downside.
“The Fed has been surprisingly clear on the direction it is going to take,” said Jason Trennert, Strategas Research Partners’ chief investment strategist. While the Fed has officially a dual mandate to provide maximum sustainable employment and stable prices, “for all intents and purposes, the Fed has only one mandate right now and that is price stability.”
Currently, the Fed’s projections suggest that the federal funds rate will rise by another percentage point by the end of the year, an exceptionally fast pace for rate hikes by historical standards.
In a small twist, the fact that the economy has remained as healthy as it was, especially the job market–it could mean the Fed will feel more comfortable staying on an aggressive rate hike path. Additionally, the fact that rates have been raised as much as they have means that when it comes time to lower rates, there is also plenty of room to lower them, says Matt Freund, head of fixed income strategies and official co-chief investment at Calamos Investments.
“The Fed generally believes it has room to tighten without lasting damage,” he says. Freund adds that he believes the Fed will be able to slow its rate hikes as we move into the next year.
A recession seems more likely
It’s not just Powell’s comments that lead market watchers to seek a more significant economic slowdown. The warning signs in the markets and the economy are becoming increasingly yellow about the potential for an economic downturn. (Technically, gross domestic product growth has already been negative for two quarters, which is generally seen as a recession.)
In the bond market, short-term interest rates are now significantly above long-term interest rates, known as the inverted yield curve, and is historically a strong indicator of a recession coming.
In the wake of the Fed meeting, “We have seen a further reversal, which suggests that the likelihood of a hard landing is increasing,” says RiverFront’s Konstantinos.
In the real economy, data is accumulating indicating a slowdown. Richard Weiss, chief investment officer for multi-asset strategies at American Century Investments, notes that surveys on the manufacturing sector almost uniformly indicate a contraction and now there is growing evidence of a slowdown in the housing market.
“It’s becoming more evident now that this isn’t getting better in the short term, it’s getting worse,” he says.
Keep an eye on the earnings outlook
Although fears of a recession have been growing for months, the stock market has been supported by continued and strong corporate earnings. The question is at what point will earnings rise and turn negative.
“People have lowered their expectations for earnings growth,” says Strategas’ Trennert, but has not yet accounted for a decline. “We’ve never had a recession without earnings dropping.” In the average recession, he says, earnings are down 30% and the average drop is 22%.
The tricky thing about this for investors is that third quarter corporate earnings will come out within a few weeks. However, they will largely reflect an economy with sustained and sustained consumer spending and a strong labor market, albeit with continued squeezing of inflation.
This will likely mean an even greater focus than usual on what companies have to say about prospects. Weiss says investors should be prepared for the bad news.
“I think we will see many in the C-suite talking about layoffs and driving forward (profit) become a lot more pessimistic,” he says. “If we’re going to get together in three or six months and make a gentleman’s bet, I think the gains will have a downside to them.”
One caveat is that inflation increases corporate earnings in nominal terms and could offset some of the downward pressure from an economic slowdown. “It’s not a fact that earnings will plummet even if the economy slows,” says RiverFront’s Konstantinos.
Uncertainty will mean volatility
The equity market has already been volatile this year thanks to ripples in Fed rate hikes and uncertainty over inflation outlook and policy response.
After the Fed meeting, Konstantinos says investors should be prepared for the constant swings in the stock market.
“I think the market will be limited and quite volatile for the next couple of months,” he says. While this may lead to further rallies like the one seen this summer, “the stock market will have a hard time making higher progress”.
Against this backdrop, Trennert notes that investors should remember the market trend to organize very strong bear market rises, but remain in a downtrend. During the collapse of the dot.com bubble from 2000 to 2002, there were eight significant rallies, she says. “The last rally was 44%, after which the market fell for another year,” says Trennert.
“It will be very difficult for the market,” he says.
Forget the “V” bounce.
During the pandemic-driven bear market, equity investors were essentially bailed out by the Fed’s extremely aggressive efforts to prop up the economy through financial markets. A rapid rebound in the markets is often referred to as a “V-shaped” recovery due to how it looks on a chart.
“This is not a pandemic that cools the economy and we have a V-shaped rebound,” says American Century’s Weiss. This is unfamiliar territory for many investors. “Many investors joined the markets after the 2008 financial crisis and only saw V-shaped recoveries” in the markets, she says.
Traders will often refer to “The Fed Put” which takes a term from the options market to say that the Fed will go deep and actually buy financial assets.
But with the Fed in a certain tightening mode, “there is no Fed Put,” says Trennert. “People have been very conditioned by the fact that everything is in the shape of a V, but most of the time it doesn’t happen.”
It will pay to stay on the defensive
Against this backdrop, investors should be prepared for difficult markets.
“We are cautious,” says Konstantinos of RiverFront. Overall, they are neutral to slightly underweight on stocks, but are more focused on generating return on a portfolio in the current market environment. He points to the difficult stock market of the 1970s as an example of how to position oneself. “A lot of your returns in the market come from dividend yields.”
In Strategas, Trennert says he favors traditional defensive sectors like healthcare and essentials, but also, unique in this economic cycle, energy stocks. “Normally you want to be out of energy stocks in a recession, because when the economy collapses, so do energy prices,” he says. However, with a shift to clean energy limiting energy companies’ desire to pump more oil despite high prices, that should limit a recessive drop in oil prices, says Trennert. “We have a feeling that energy companies will distribute a lot of cash to shareholders and dividend yields will remain solid.”
American Century’s Weiss says his side have been defensive since the start of the year, favoring value over growth, along with defensive stocks. “Let’s stay there,” he says. “It will be tough.”
Correction (September 23): An earlier version of this story misspelled the name of Richard Weiss, American Century Investments chief investment officer for multi-asset strategies.