Federal Reserve Divorcing from the Stock and Bond Markets

January 28, 2022

• The Federal Reserve appears to be focused on stamping out inflation by raising interest rates to the detriment of the economy and financial markets.
• The direction of Federal Reserve appears to be more restrictive than investors expected and poses a growing risk of economic recession in 2023 and 2024.
• Stock and Bond markets are off to a rough start to 2022.-Corporate earnings are generally off to a good start with a few exceptions
• Getting defensive in portfolios by raising cash and reducing high P/E stocks
• Adding to floating rate investments in bond portfolios

Federal Reserve Divorce from Financial Markets

While there are other factors, the primary reason for the year-to-date rise in bond yields and the 10% drop in the SP500 is due to more aggressive change in Federal Reserve “Fed” policy. The fiasco started on January 4th with the release of the minutes of the December meeting of the Fed. The minutes of the meeting revealed that the Fed is now taking a focus on removing the financial accommodations it enacted during the Covid crisis to support the bond market but is doing so at a more rapid pace than investors anticipated. During yesterday’s Fed press conference after their board meeting, Chair Powell responded to a question about the drop in the financial markets with the comment that “the economy is much stronger than in 2018 (when the Fed last raised interest rates) and could handle much higher interest rates.” Chair Powell’s response triggered a 3% drop in the SP500.

While investors have been expecting higher interest rates, they did not as expect them to be as high as the Fed is inferring. On December 31st, the futures market predicted 3 rate hikes to 0.8% by year end 2022. This morning, the futures market now sees 5 rate hikes and a year-end Fed Funds rate at 1.25%, and a major bank says that 7 hikes are possible. Furthermore, there is a growing sense that Fed wishes to have the Fed Funds rate, a proxy for short-term interest rates which they control, in the range of 2.5% to 3% or higher. Chair Powell targeted this rate in 2018 and that might be the reason for his bias.

To sum up the Fed’s new war on inflation, the speed of its change in monetary policy will lead to more losses in the financial markets. Yes, now the Fed is no longer a friend to stock and bond investors. The “divorce papers” were served during yesterday’s press conference. Stocks and bonds will not receive any “alimony” from the Fed going forward.

Two Year Treasury Yields Spiking

Other factors troubling the financial markets

The lingering CV-19 Omicron variant hit the economy in December 2021 and continues into January 2022. For the vaccinated and boosted individuals, it is generally not life threating but a short illness. Still, it is enough to cause another disruption in businesses, schools, and pretty much any organization. If medical experts have it right, the Omicron effect on the economy will diminish soon.

What will not diminish soon is Russia and Vladimir Putin from their plans to geographically expand. Mr. Putin is arguably one of the smartest dictators in the world. Russia’s potential invasion of Ukraine has spiked up oil and natural gas prices. Russia is quickly rebuilding its financial resources with this strategy. Putin’s leverage over the oil markets is another good reason to make your next car purchase an EV or hybrid. The U.S. still imports Russian oil.

Economic comments

Gross Domestic Product rose at an annual pace of 6.9% in the fourth quarter 2021. While the headline number looks super strong, it was hiding less optimistic trends. The large growth was mostly due to inventory investment and no final sales. Retail sales in December 2021 actually declined. The growth of personal income moderated in December. A key change in the economy in 2022 will be the lack of fiscal, or government spending. With the Build Back Better bill failing and the child tax credit expiring, two important factors that supported future growth expectations are now gone. The downturn in the financial markets and bitcoin will also be headwinds against consumer spending.

Payroll inflation is running close to 5% which is hot. Employers are being very generous lately due to the shortage of workers. The virus is the big factor in the drop in the number of workers. The virus is a “supply shock,” a technical economics term meaning that it affects the normal economic balance between demand and supply. It would be reasonable to account for the rise in inflation due to excessive demand from consumer spending and the lack up supply in the labor market. The Fed’s raising interest rates will do nothing to increase the supply of workers in a declining economy.

Portfolio action and our strategy for what may happen next

Since late last year, we have been reducing exposure to stocks and increasing cash and floating rate securities. At present, equity exposure is at the lowest percentage of portfolios in years. With the SP500 down about 10%, NASDAQ down about 15%, and small caps down about 20% for the year so far, the current phase of the sell-off in stocks may be over soon. Since the Fed is just about to begin raising interest rates, there is plenty of risk to come in the months ahead.

In most portfolios, a large cash buffer exists. Floating rate securities and the Fidelity Short Term Conservative Bond Fund are our preferred options.

In the equity portion of portfolios, it has been a challenge to find stocks that will hold up the best while also offering potential appreciation. In general, favored equities are those that have stable businesses with recurring revenue streams, no need to borrow funds, able to navigate supply chain issues better than their competition, and have long-term growth potential. The mega technology holdings have all these attributes. Microsoft, Apple, and Tesla reported the strongest results and all three have very strong financials. Energy holdings, such as National Fuel Gas and Oneok are holding up well as the price of oil and natural gas are both rising. Healthcare stocks are positioned for recovery in patient activity after the Omicron variant runs it course. Intuitive Surgical is best positioned after a sharp sell off in its stock due to muted guidance. On a similar strategy, a growing position in Disney has been taken in anticipation of a travel recovery this summer and beyond.

As the chart of the SP500 below shows, the stocks are sitting on an important level where the October rally began in October. In the short term, a bounce maybe possible.

In the future, there will be an opportunity to shift back into equities. With the risk of higher interest rates, its best to position portfolios for more rough times until the Fed’s new policies are better understood.