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The sea-sickening ride through choppy market waters of 2022 continued this week, as inflationary pressures persisted. Investor, consumer and business expectations unwound and global central banks’ unprecedented monetary experiment sharply reversed in the second quarter. Bond yields spiked and liquidity proved to be the “coward” it becomes in stressful times, slicing into stock and bond market valuations. The S&P 500 slid into a bear market (defined as a market decline of 20% from a prior peak), as investors feared that red-hot inflation will prompt more aggressive rate increases from the Federal Reserve during the committee’s meeting this week.
Fed officials have now conceded that monetary policy was too easy for too long. Fed Chairman Jerome Powell and other policy officials have retired their use of the term “transitory” and are working to fight inflation by raising short-term rates and more-aggressively reducing the size of the Fed’s balance sheet.
The consequences of these policy decisions are reflected in yields, particularly in shorter-duration assets. The 2-year Treasury yield is a fitting example. The 2-year is a useful proxy for the short end of the full-spectrum “yield curve” and also typically projects or anticipates the market’s expectations of the Fed Funds rate at year-end. The yield on the 2-year was rangebound between 0.50% and 0.75% from March 2020 through year-end 2021. As of this writing that security’s yield is hovering around 3%, a sharp and historically-spectacular rise. As short-term rates have ripped higher, equities have been dragged down sharply, which you can see visualized in the chart below.
Officials are hoping they can stick a “soft landing,” an oft-used reference to an economic slowdown that curtails inflation without sending the economy into a recession. In the recent past, the Fed has rescued falling equity markets by easing off on projected interest rate increases – this is commonly referred to as the “Fed Put.” This time it may well be different given that consumer price index (CPI) levels are at 40-year highs, gas prices are above $5 a gallon nationally and there is upward pressure on wages and rising shelter costs. The Fed knows it must remain vigilant to effectively combat inflation, so despite falling equity markets the Fed will most likely not get sidetracked and pull back on expected rate increases. In fact, we may see a larger increase this week (a 0.75% hike rather than the consensus 0.50%) than was expected just a week ago.
For more detail on where past policy misjudgments have been made, we would call readers’ attention to several of our past Quarterly Perspectives commentaries. At the end of this quarter we will provide for clients a deeper dive into how we are looking at markets going forward, but we have generally proceeded cautiously during a period of increasing surprises and disruption.
We always endeavor to allocate capital to high-quality assets that hold and build value across market cycles. Market sentiment, and thus pricing, sometimes diverges with timing. In these circumstances we seek to use dislocation to rebalance portfolios, capture capital losses for taxable investors, and position investments opportunistically. This often requires searching for reasons to be optimistic (greedy) when markets and sentiment are pessimistic (fearful).
One area we view more optimistically today and where many clients may see portfolio changes is in the management of cash. We wrote during the recent period that given Fed policy and market action there was no alternative to stocks. Diligent readers will recognize our shorthand for this phenomenon as “TINA” – There Is No Alternative). Today, the 3% short-term rates mentioned above means that portfolio construction can shift as there are more and now-compelling options for investment. In keeping with prior nomenclature, we will refer to this as “TARA” – There’s A Reasonable Alternative. As a result, we will be incorporating some new cash and short-term equivalents into portfolios across certain accounts and portfolio models.
