New losses in the stock and bond markets after this week’s Federal Reserve meeting make one thing clear to investors: be prepared for even more turbulence in the future.
The central bank raised the Federal Funds rate by 0.75% this week for an unprecedented third-straight meeting, pushing the funds rate target to 3.0% to 3.25%. At the same time, Fed officials indicated they expect continued rate hikes that could push this key short-term rate to 4.6% next year.
In addition, while it can sometimes be difficult for investors to interpret what Fed officials mean, the message was clear when Chairman Jerome Powell spoke after the decision to raise rates aggressively again: The Fed will do whatever it takes to curb inflation. to penetrate 40-year highs. And to do that, the economy will slow down.
“We need to get inflation behind us. I wish there was a painless way to do that, there isn’t,” Powell said. That pain, he said, includes higher rates, slower growth and a weaker job market.
And although Powell didn’t say it directly, it is increasingly expected to involve a recession, not just a so-called soft landing where the economy cools but doesn’t contract.Read:Markets give thumbs down to the Fed
“As an investor, it’s not an easy message to hear,” said Chris Konstantinos, chief investment strategist at the RiverFront Investment Group.
Here are six takeaways for investors:
Rates will continue to rise
The clearest conclusion from the Fed meeting is that short-term interest rates will continue to rise, and they will continue to raise interest rates until officials feel that inflation is really around the corner and going down.
“The Fed has been surprisingly clear about the direction it is heading,” said Jason Trennert, chief investment strategist at Strategas Research Partners. While the Fed officially has a dual mandate to deliver maximum sustainable employment and stable prices, “the Fed currently only has one mandate and that is price stability.”
Currently, the Fed’s forecasts suggest that Federal Funds interest rates will rise another percentage point by the end of the year, an exceptionally fast pace for rate hikes by historical standards.
In a bit of a twist, the fact that the economy has remained as healthy as it was – especially the job market—may mean the Fed will be more comfortable following an aggressive rate hike. Plus, the fact that rates have been raised as much as they have means that when it comes time to lower rates, there’s plenty of room to lower them, too, said Matt Freund, head of fixed income strategies and co-chief investment associate at Calamos. investment.Read:Beyond Meat COO suspended after altercation
“The Fed generally believes they have 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 go into next year.
A recession seems more likely
It’s not just Powell’s comments that keep market watchers looking for a more meaningful economic slowdown. The warning signs in the markets and the economy are increasingly blinking yellow about the potential for an economic downturn. (Technically, gross domestic product growth has been negative for two quarters, which is generally seen as a recession.)
In the bond market, short-term rates are now significantly above long-term rates, known as an inverted yield curve, and historically a strong indicator that a recession is on the way.
In the wake of the Fed meeting, “we have seen a further inversion, suggesting that the odds of a hard landing are increasing,” said RiverFront’s Konstantinos.
In the real economy, data is accumulating that there is a slowdown. Richard Weiss, chief investment officer for multi-asset strategies at American Century Investments, notes that manufacturing surveys almost uniformly point to a contraction and that there is now mounting evidence of a slowing housing market.Read:Alameda Research ‘happy to return’ $200M loan to Voyager Digital
“It’s getting clearer now that this thing isn’t getting better in the short term, it’s getting worse,” he says.
Keep an eye on the earnings outlook
While fears of a recession have been growing for months, the stock market has been supported by continued strong corporate earnings. The question is at what point the profit will turn and become negative.
“People have lowered their expectations for earnings growth,” Strategas’s Trennert said, but aren’t expecting a decline yet. “We’ve never had a recession without earnings falling.” In the average recession, he says, profits fall by 30% and the median decline is 22%.
The tricky part for investors is that corporate earnings for the third quarter will be announced within a few weeks. However, they will largely reflect an economy with continued strong consumer spending and a strong labor market, albeit with continued inflation pressures.
That probably means an even more than usual focus on what companies have to say about the outlook. Weiss says investors should brace themselves for bad news.
“I think we’re going to see many in the C-suite talking about layoffs and the forward (revenue) guidance getting a lot more pessimistic,” he says. “If we want to get together in three to six months and place a men’s bet, I think the profit will be negative.”
One caveat is that inflation nominally increases corporate profits and could offset some of the downward pressure from an economic slowdown. “It’s not a foregone conclusion that profits will collapse even as the economy slows,” said RiverFront’s Konstantinos.
Uncertainty means volatility
The stock market has already been volatile this year thanks to the ripples of Fed rate hikes and uncertainty about the inflation outlook and policy response.
After the Fed meeting, Konstantinos says investors should brace themselves for continued back and forth swings in the stock market.
“I think the market will be strong and quite volatile in the coming months,” he says. While that could mean more rallies like this summer’s, “the stock market will have a hard time moving forward.”
In that environment, Trennert notes that investors should remember the market’s tendency to stage very strong bear market rallies, but remain in a downtrend. During the collapse of the dot.com bubble from 2000 to 2002, there were eight key rallies, he says. “The last rally was 44% and then the market fell for another year,” says Trennert.
“This is going to be very difficult for the market,” he says.
Forget a ‘V-shaped’ bounce
During the pandemic-driven bear market, equity investors were essentially rescued by the Fed’s extremely aggressive efforts to support the economy through the financial markets. A rapid recovery in the markets is often referred to as a “V-shaped” recovery because of how it looks on a chart.
“This is not a pandemic that is making the economy cold and we have a V-shaped rebound,” said American Century’s Weiss. This is unknown territory for many investors. “Many investors entered the markets after the 2008 financial crisis and only saw a V-shaped recovery” in the markets, he says.
Traders often refer to “The Fed Put,” which is an option market term to say that the Fed will come in at the bottom and will basically buy financial assets.
But with the Fed in a determined tightening mode, “there is no Fed Put,” Trennert says. “People are very conditioned that everything is V-shaped, but most of the time it doesn’t happen.”
It will pay to stay defensive
Against this backdrop, investors should brace themselves for difficult markets.
“We are cautious,” said RiverFront’s Konstantinos. In general, they are neutral to slightly underweight equities, but are more focused on generating returns in a portfolio in the current market environment. He points to the difficult stock market of the 1970s as an example of how to position yourself. “A lot of your returns in the market came from dividend yields.”
At Strategas, Trennert says they favor traditional defensive sectors such as healthcare and consumer staples, as well as, unique to this economic cycle, energy stocks. “Normally you would run out of energy supplies during a recession because when the economy goes down, so do energy prices,” he says. However, with a clean energy shift limiting energy companies’ desire to pump more oil despite high prices, that should limit a recessive drop in oil prices, Trennert says. “We feel that energy companies will return a lot of money to shareholders and that dividend yields will remain robust.”
American Century’s Weiss says his team has been defensive since the beginning of the year, favoring value over growth along with defensive stocks. “We’ll stay there,” he says. “It’s going to be tough.”
Correction (September 23): In an earlier version of this story, Richard Weiss, chief investment officer for multi-asset strategies at American Century Investments, was misspelled.