To support the economy after COVID, the Federal Reserve massively increased their holdings of mortgages and bonds, totaling $9 trillion by the end of first quarter 2022. That monetary stimulus, combined with fiscal stimulus from Congress, created an economy so hot that it is overheating. Russia’s invasion of Ukraine had a small contribution as well, functioning as a wake-up call to investors. The consumer price index (CPI), a general measure of inflation, reached 8.5% in March to arrive at a level not seen since the end of the Carter administration. The producer price index (PPI) is seen as a leading indicator and is shown below with the longer running finished goods index. The PPI has risen higher to 11.2% a level also not seen for decades. Both measures appear on the upswing and rising dramatically.
To address the overheating, the Federal Reserve recently signaled a change to higher rates and an unprecedented unwinding of their largest ever balance sheet. Rather than continuing to purchase Treasuries and mortgages, the central bank will now shrink their holdings by $95 billion a month. If buying these bonds supported markets, unwinding them is likely to have the opposite effect. The hope is that these actions will be strong enough to slow the economy without being so strong that they send us into a recession.
Given the previously outlined scenario, one would expect the market to be cautious. However, after a brief drop from the beginning of the year to mid-March, the market rallied back almost to previous highs. On the surface the economy is running stronger than it has in decades, demonstrated by an unemployment rate down to 3.6% and $2.5 trillion in additional consumer savings now vs pre-pandemic. Earnings season will generate headlines reflecting that boom in our economy, but we need to remember that those earnings are backward looking. The central bank’s planned actions hope to reign in that unrestrained optimism by the end of the year.
At the latest Fed meeting, their own projections indicated 50 basis point increases (double the normal amount) at each of the three remaining meetings of the year. “I would like to get there in the second half of this year… We have to move,” to get ahead of inflation running at triple the Fed’s 2% target, Bullard said. “We are talking about bigger moves than we have made in a long time.” These actions by the Federal Reserve should create an environment very different from the one we are in now, especially when combined with balance sheet reductions of $95 billion per month. Luckily, we have seen similar environments before.
In our annual update of our investment projections, Equitas looked specifically at asset class behavior in both a rising rate environment and also in a high inflation environment. The charts below represent a portion of the research Equitas has performed on both rising rates and rising inflation environments. A few differences immediately jump out, particularly the wild variance in performance of growth and mid cap equity. Some asset classes appear to weather both periods satisfactorily, like value equity, international equity, and real assets such as property and commodities.
As we continued our research, the growth of the underlying economy emerged as the key factor on asset class performance. If inflation is high and rates are increasing because the underlying economy is doing well, most risk assets (including equities) will also do well. However, if there is a shock, or if rates increase enough to be a shock themselves, the economy risks recession with negative impacts on most asset class. Bonds and MLP pipelines have historically held up better under these conditions.
Timing the transition of the economy is extremely difficult even for experts. One frequently watched barometer is the relationship between long dated bonds and shorter dated bonds, represented by the spread between 10-year and 2-year treasury notes. Typically, the yield on longer bonds is higher to compensate for the longer time period, but in periods of stress, short term lending is considered riskier with a higher yield. Traditional wisdom says that recessions come within two years of an inverted yield curve. This relationship is shown in the graph below.
The uncertainty of timing leads to our preference in crafting a strategic allocation that can perform reasonably in most markets, with an overweight on classes that have shown resiliency. We also prefer active managers who are able to find low debt companies with pricing power for their potential to outperform index returns over the long run. As always, we are keeping our eyes towards rebalancing back to target as opportunities present themselves.
Charles Dow, 1900
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC, located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high-net-worth family offices.