Last week, the Federal Reserve hiked the federal funds rate by 50 basis points (0.5%). This increase was in line with market expectations and the second after initial liftoff occurred at the March meeting. The Fed is fighting the highest inflation readings since the 1980s. In our view, the roots of the current inflationary environment were planted by the extraordinarily long period of easy monetary policy following the financial crisis. These roots took hold over the course of the next decade, then grew markedly with the global response to COVID. Zero interest rates, unprecedented stimulus and the collapse of the just-in-time global supply chain have combined to create supply/demand imbalances with strong upward price pressures.
Interest rates have risen across the curve, albeit from very low levels. The 5-Year Treasury Note rose from 0.2% in July, 2020 to a recent level of 3.0%. While the 3% mark isn’t high from a historical perspective, it is nearly a 15-fold increase. Similarly, the 10-Year yield rose from 0.6% to 3.0% over that same time frame. The average 30-Year mortgage rate was 3.5% six months ago. Today it is nearly 5.5%. As we have discussed with clients at length, technology stocks are some of the most vulnerable to a rise in rates. The greater a security’s valuation that is predicated on future earnings, the more a higher discount rate impacts the present value. To be clear, we are not anti-technology. There continues to be a very high level of technological disruption occurring right now. That is unlikely to reverse. But the road to higher rates is paved with risk. This is what happens when high valuations meet an aggressive Fed.
We do not envy the position that the Fed is in. They are under constant criticism by market participants who each have their own motives. Their tools are blunt. Changes in interest rates operate with a lag. There has never been an attempt to decrease a balance sheet this large. For reference, the Fed’s balance sheet was ~$1 trillion prior to the financial crisis. That number quadrupled to ~$4 trillion between 2010 and 2015. It leveled out then jumped again with the response to COVID. It currently stands at ~$9 trillion. It isn’t hard to see why investors are worried about the normalization of rates that is occurring at the same time the Fed is attempting to reverse the easy monetary policy they have employed over the last decade plus.
However, the Federal Reserve is not under any mandate, other than their stated one: “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” As Jerome Powell stated at their June meeting, “If the situation turns out to be different than we thought, we’re not going to stick with something that isn’t working.” The first four months of the year have seen the worst market returns over that time frame since 1939. The bond market has witnessed the worst stretch since 1842. Over half of the stocks in the NASDAQ are down over 50% from their recent highs.
The last nineteen bear markets have averaged a decline of 37% and a mean duration of 289 days. The recent peak in the S&P 500 was in January, at 4,819. As of this writing, the S&P 500 is down ~18% from its high. While we are clearly in a bear market for technology stocks, we haven’t quite gotten there yet for the broader markets. The biggest determinant, in our opinion, will be the future datapoints released on inflation. There are signs that inflation is beginning to moderate, but data is likely going to be mixed for some time.
It would be easy to write a happy ending to investing in the year 2022. Inflation comes down, the Fed gets less aggressive, and asset prices rally. It would also be easy to write a story where inflation remains stubbornly high, rates continue to rise, and asset prices struggle considerably from here. The uncomfortable reality is that nobody knows. We are constantly investing in an uncertain world with unknown future outcomes, which is why we believe in process and not prediction. Every long-term investor must live with the knowledge that they will go through difficult, humbling times. It is also why we have cash and short-term bonds. Our expectation is that this year will continue to be volatile and challenging. Attractive opportunities will reveal themselves, and we are in a position to take advantage of them. Thank you for allowing us to be your private wealth management team.