THE TIPPING POINT

All Eyes on the Consumer and Fed

THE TIPPING POINT

All Eyes on the

Consumer and Fed


The Federal Reserve Board has begun to raise rates and is expected to continue hiking for the foreseeable future to combat eye-popping inflation. The hikes are also aimed at restoring the Fed’s credibility after the damage done by sticking to their ‘’transitory’’ inflation view for too long.

But current events are making the Fed’s job increasingly complex. The Russian invasion of Ukraine and the resulting war between the two nations have sent commodity prices—particularly oil—soaring. Rising prices are also starting to spread out to affect multiple sectors of the economy. And supply chain backlogs that have impacted inventories continue to challenge both businesses and customers.

With an uncertain economic outlook, are consumers—who account for about two-thirds of the U.S. economy—prepared to continue spending, or are they about to conserve their cash?

The overarching questions that are important for financial advisors, their clients, and portfolio managers like us are:

Where could we be going, and how may the future affect goals-based planning and investment management?

Horizon Investments’ Chief Investment Officer Scott Ladner and Head of Portfolio Management Zachary Hill tackle these questions in this Q&A series.

 

Where could we be going, and how may the future affect goals-based planning and investment management?

Horizon Investments’ Chief Investment Officer Scott Ladner and Head of Portfolio Management Zachary Hill tackle these questions in this Q&A series.

The economy and the financial markets have faced a pretty remarkable line up of challenges so far this year—as evidenced by the performance of most asset classes. Are there certain factors that you think are more responsible than others for the type of environment we’ve experienced?

It’s been a tough go for equities; although, we have seen some reversals of the weakness in stocks toward the end of the quarter, while core U.S. bonds delivered their worst quarterly total return since 1980. The forces driving market volatility include everything from continued concerns about Covid variants and supply chain issues to sharply higher inflation rates, and that’s before the Russian invasion of Ukraine caused oil and gas prices to soar.

That said, we see the bulk of the market’s weakness of late stemming from just how rapidly the Federal Reserve Board (Fed) has shifted toward tighter monetary policy to fight inflation. As widely expected, the Fed raised the federal funds rate at its March 2022 meeting for the first time since 2018. But what really got investors’ attention was that the Fed suggested it would raise that rate nine additional times over approximately the next two years. That was a big increase from December of last year, when Fed officials telegraphed only about six total rate hikes through the end of 2023.

This major shift in the Fed’s outlook—from a low-rate, full-employment-at-any-cost focus to a higher rate, contain-inflation-at-any-cost emphasis—was quite sudden and generally unexpected among investors.

 

What are the potential implications of that shift for investors? Do you think the multi-decade trend of falling bond yields could be ending, for example?

It’s important to note that the valuation compression we’ve seen among stocks this year in response to the Fed tightening is essentially in line and consistent with the market’s response to past episodes when the Fed has tightened monetary policy. In other words, the market’s behavior in this environment isn’t out of the ordinary. The equity drawdowns look a lot like those seen in previous non-recessionary market sell-offs.

On the bond side, this year’s price action is an example of what can happen when interest rates are at record lows and future expectations shift aggressively – there is little yield cushion to mitigate the capital loss due to falling bond prices.  The Bloomberg U.S. Aggregate Bond Index, the most common measure of broad investment grade bonds in the U.S., has declined 8.7% from its peak in mid 2020.  That drawdown represents the largest for core U.S. bonds since the early 1980s.  Given the low level of credit spreads and uncertainty around inflation and Fed policy over the next two years, it is too soon to call an end to the recent losses in core bonds.  But some parts of the bond market are starting to become attractive again and may become more so if interest rates continue to climb in the coming quarters. 

 
This year investors have had to deal with a valuation shock to both stocks and bonds driven by a shift in Fed policy.  Where does that leave investors looking out over the rest of 2022?
 

There are two key questions that we think investors need to be paying attention to, and that we ourselves will be very focused on in the short and medium term:

  1. Will the Fed need to raise rates more than the market expects?
  2. Will economic growth and corporate earnings take a hit?

Examining the first question of the Fed, the answer largely comes down to inflation—which we see as broadening out from just the pandemic-impacted sectors like food, shelter and used vehicles. In other words, prices are rising essentially “across the board.” For now, the market expects the Fed to quickly raise rates to historically neutral levels and then stabilize. For that to occur, however, inflation will need to moderate meaningfully throughout 2022. The strength of the labor market, consumer spending patterns and supply chain conditions all will impact the pace of inflation.  Our focus is on these factors to assess whether or not the Fed decides it needs to raise rates more than the 10 total hikes it currently has planned.

So the path of inflation will determine the outlook for Fed policy this year, and we know what you are watching on that front.  What about underlying economic growth and the read through to corporate earnings? 

The economic and corporate profit growth will depend largely on the U.S. consumer, and the outlook here is uncharacteristically mixed:

  • On the one hand, consumer confidence is in the basement—stalled out at levels usually seen during recessions. Pessimistic consumers may close their purses and wallets until they’re more sanguine.
  • But in stark contrast to the way they say they feel, consumers’ actual financial health remains robust—they’re carrying low levels of debt, the job market is strong, and wages are on the rise. This gives consumers plenty of “dry powder” to go out and spend.
 

After two years of curtailed plans and too much time at home, we expect that consumers will act based on their underlying economic position, not their sour moods.  Strong consumer spending should continue to power economic growth in the U.S. for the remainder of this year. 

Meanwhile, corporations have used the low levels of interest rates over the last two years to improve their capital structures.  With healthy balance sheets and a consumer with the ability and willingness to spend, the outlook for corporate earnings is positive as well.  

 How does the war between Russia and Ukraine factor into your outlook here at the end of the first quarter?

It’s a concern, of course, given the potential impact of the invasion on gas, wheat and other commodity prices going forward — with an upward bias to near term inflation.  The potential for the conflict to spread to other nations and what that could mean globally is also a concern, but we aren’t trying to predict the direction of the war. In such a fast-moving situation, it takes time for consensus estimates of the economic outlook to adjust. The economics team at JP Morgan publishes weekly revision indices for growth for countries and regions across the globe.  Based on their estimates, the hit to growth in the near-term is concentrated mainly in Europe, while the growth outlook in U.S. and China, two of the largest drivers of global growth, are not significantly impacted.

Do today’s elevated levels of inflation change your underlying views on the level of interest rates and the dynamics of the economy?

We are skeptical of a paradigm shift to higher rates and hotter inflation. Current financial market pricing, in our view, is skeptical as well.

We have talked before about the reasons why we think this is ultimately a temporary inflation phenomenon (see our 2022 inflation outlook article for a comparison of worker productivity and labor costs in the 1970s, 2000s and now), and we think those reasons are still valid:

  • Technology advancements are generally deflationary as it reduces friction in the economy and allows for more to be accomplished in either less time, with fewer workers or with a more efficient use of raw materials and resources.
  • Worker productivity continues to trend higher, meaning more goods and services are produced at lower cost, which tempers inflation. Said another way, the current trend suggests there will be more things made and services rendered than money in people’s pockets to buy them, leading to downward price pressures in the long run.
  • An expanding retirement population in the U.S. and worldwide tends to spend less and acts as a drag on economic growth.
 

This question on the structural nature of inflation matters greatly because of the trends we have observed around interest rates and hiking cycles.  As the circled portions in the chart below indicate, the historical trend is lower and lower yields because the fed funds rate has peaked at lower and lower levels, from 6% to 5% to 2% over the last two decades.

In fact, the end of a Fed hiking cycle may be more impactful to investors than the beginning, at least if the chart above is any guide. Will this time continue or break the pattern? Will inflation and a commodity price shock force the Fed to act differently, meaning it hikes to 3% or 4% or 5%? And, if that should happen, will that signal a change in trend to higher and higher terminal fed funds rates in the years ahead? 

Zooming out a bit, have recent events changed any of your underlying views?  How are you thinking about portfolio construction to address the needs of clients? 

In a word, no.  Within stocks and bonds, our flexible approach is built for such an environment.  By combining quantitative and qualitative techniques to navigate changing market trends, our investment team continues to seek out attractive potential opportunities for long-term gains.  Against a backdrop of rapidly evolving outlook for Fed policy and global divergences in economic growth, we expect to uncover mispricings in the coming quarters.

At the portfolio construction level, while bond yields have risen, we believe it is important to put them in the context of history and to compare them to investors’ goals. The 10-year U.S. Treasury yield ended the quarter at 2.4%, up substantially from the summer of 2020, but well below its 40-year average of 5.4%.  Indeed, long term bond yields have been higher than today’s levels 80% of the time over that period.  And given the return needs of investors across the GAIN, PROTECT, and SPEND stages, especially in light of today’s elevated inflation, bond-heavy strategies are unlikely to provide what is needed. 

We have been vocal about our belief that “the 80/20 is the new 60/40,” and nothing in the last year has changed that view.  But in today’s high volatility environment, it may be a good idea to take another look at your clients’ portfolios to ensure they are properly calibrated for today’s markets.  Typically, deploying risk management strategies or rightsizing portfolio allocations can make a difference in the early stages of a rising volatility environment, not after the storm has passed.

DISCLOSURES

The commentary in this report is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here are not investment recommendations, but rather opinions that reflect the judgment of Horizon as of the date of the report and are subject to change without notice. Opinions referenced are as of the date of publication and may not necessarily come to pass. Forward looking statements cannot be guaranteed.

We do not intend and will not endeavor to provide notice if and when our opinions or actions change. Horizon Investments is not soliciting any action based on this document. This document does not constitute an offer to sell or a solicitation of an offer to buy any security or product and may not be relied upon in connection with the purchase or sale of any security or device.The investments recommended by Horizon Investments are not guaranteed. There can be economic times where all investments are unfavorable and depreciate in value. Clients may lose money.

Information has been obtained from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Horizon Investments Gain Protect Spend and the Horizon H are registered trademarks of Horizon Investments.

© 2022 Horizon Investments, LLC.

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NOT A DEPOSIT | NOT FDIC INSURED | MAY LOSE VALUE | NOT BANK GUARANTEED | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY

The commentary in this report is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here are not investment recommendations, but rather opinions that reflect the judgment of Horizon as of the date of the report and are subject to change without notice. Opinions referenced are as of the date of publication and may not necessarily come to pass. Forward looking statements cannot be guaranteed. We do not intend and will not endeavor to provide notice if and when our opinions or actions change. Horizon Investments is not soliciting any action based on this document. This document does not constitute an offer to sell or a solicitation of an offer to buy any security or product and may not be relied upon in connection with the purchase or sale of any security or device. Information has been obtained from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Horizon Investments, the Horizon H, and Gain Protect Spend are registered trademarks of Horizon Investments.

© 2022 Horizon Investments, LLC.

NOT A DEPOSIT | NOT FDIC INSURED | MAY LOSE VALUE | NOT BANK GUARANTEED | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY NOT GUARANTEED | CLIENTS MAY LOSE MONEY | PAST PERFORMANCE NOT INDICATIVE OF FUTURE RESULTS

© 2022 Horizon Investments, LLC.
HIM012022
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