The Federal Reserve has increased interest rates against the backdrop of war and recession risk. How’s this going to affect you? What should we do about this?
The Fed has increased the rates one quarter percent. It’s the first of projected eight increases for a total increase estimated to be 2% of the rest of the year. This is against a backdrop of US mortgage rates that have topped 4%. Gas prices are above $4.00, oils above a hundred dollars. We’ve got supply chain and labor shortages. And of course, we got this war in the Ukraine. So there’s a lot of uncertainty in the environment. The challenge for the Fed is slowing inflation without tipping the economy into recession. Now, any economic historian will say, “If you go back 50 years or 70 years, the Fed typically doesn’t pull this off. They typically nip the inflation in the bud, but drive the economy into recession.”
So the history of this maneuver is not great. However, that hides the fact that the memos out, how difficult this is and how delicate of touch you need. So the Fed’s history more recently has been better. In other words, there is a risk of recession, but it’s not a competence risk.
The Fed is fairly competent, and this will be interesting to say the least. The challenge for markets though, is the denominator and the valuation of anything. Higher interest rates hurt the valuation of the future cash flows that are any company bond or other investment. Bonds, in particular, are at risk because when interest rates go up, the valuation of the principle drops a little bit. Yes, you can hold them to maturity, but you’ve got reinvestment risk. All that money now can’t be reinvested until it’s mature.
So it’s really six to one half, a dozen of the other. Inflation as it is right now, is also shredding bonds. In fact, inflation over the last two years probably has hit bond portfolios by 15%. It’s just not obvious. So, many clients think of bonds as safe and equities as risky because of the volatility, but a guaranteed 15% loss over two years is anything but safe. Equities at least recover.
When it comes to stocks, there is this rotation from growth to value. In fact, the growth bear market has been a full negative 25% over the last few months, whereas values pretty much held its own. This is no great surprise. In fact, the videos we put out will say, “Value versus growth have almost never been so far apart.” You don’t even have to be a value shop to understand that growth is expensive at this point in time. Growth is particularly affected by increased interest rates. But I don’t want that to disguise or hide the fact that the only game in town right now are ownership assets. Bonds, CDs, anything where someone owes you money that’s devastated by interest rates and it’s devastated by inflation.
Equities, we’re going to see some bumps. Hold onto your hat. This could be an interesting ride. But in the end, in the long time ownership assets, and that includes your house, your stock portfolio, real estate investments, your business. It’s really the only game in town. We wish you the best of investing success. Thank you.
Compton, Eric. “Fed to Investors: Just the Beginning for Rate Hikes.” Morningstar, Inc., 16 Mar. 2022, https://www.morningstar.com/articles/1084704/fed-to-investors-just-the-beginning-for-rate-hikes.