The economy seemed to be moving in opposite directions in July. While economists were debating whether we had entered a recession, employers were filling jobs at a blistering pace. By the end of the month, with job growth more than double the forecasts, investors put recession fears on hold to worry anew about inflation. “Markets are a very complicated Impressionist painting,” Pimco CEO Emmanuel Roman said in a Financial Times interview (15-July). “Different pieces contribute to the story.” Only, this story isn’t following any previous script.
The Labor Department reported that employers added 528,000 non-farm jobs in July, driving unemployment down to a 50-year low of 3.5%. Job growth data for the previous two months was revised upwards, which was all the more surprising given declining GDP for two consecutive quarters and souring consumer sentiment.
While it is too early to declare risk of U.S. recession over, the pace of job growth stoked fears that the Fed will raise interest rates faster than anticipated and slammed the brakes on a recovering bond market. Treasury yields rose and the yield curve inverted, with the two-year note climbing 41 basis points above the benchmark 10-year. The bond market sagged as predictions of interest rate hikes, previously ranging from a high of 3.5% to 3.75% by year-end, jumped to 4%.
But just as market watchers were wrong about their job-growth projections, they may also be wrong about inflation. On August 5, Paul Krugman declared in the New York Times: “Inflation is coming down. Fast.” While some might take issue with the “fast” part of that statement, signs in early August point to both a shift in consumer and business sentiment. Gas prices are moderating, with most stations across the country now charging $4 or less a gallon. Food prices are stabilizing or coming down, feeding a slight uptick in consumer confidence. Small businesses are also in a better mood. Prices on raw materials are still rising, but at a slower pace than in many months. And with July hiring double the expectations, the squeeze on labor is loosening.
Is there light at the end of the tunnel? Perhaps. But again, this story isn’t following any previous script.
Quantitative Tightening Complicates the Picture
Quantitative easing (QE) has been de facto Fed policy ever since the great global recession of 2007-2009. When Covid shut down the economy in early 2020, central banks made access to cheap money even easier for businesses, consumers, and anyone else who would take it. By 2021, however, the Fed came under increasing pressure to tighten its balance sheet as stock valuations soared and the spark of inflation threatened to become a forest fire.
Now we have entered a new stage of quantitative tightening (QT), as the Fed attempts to unwind $4.5 Trillion built up on its balance sheet since the beginning of the pandemic. The program began slowly as the Fed let $30 billion in Treasuries and $17.5 billion mortgage-backed securities roll off its balance sheet (as opposed to reinvesting). In September the pace is expected to double, to $60 billion and $35 billion, respectively. The Fed has suggested that this could go on for 2.5 years, ultimately shrinking the balance sheet from $9 trillion to $2.5 trillion.
Wall Street may not be paying enough attention, according to Barron's (Lisa Beilfuss, 5-August 2022) and others studying the impacts of QT. The market has only witnessed one other period of QT, making it difficult to price in the impact on interest rates. Barron's interviewed Joseph Wang, a former senior trader on the Fed’s open markets desk, who pointed to the chaos that erupted in the repo market and fears of liquidity the last time the Fed attempted tightening, prompting an early end to the program. Others disagree, saying QT will run “more or less on autopilot.” Fact is, nobody knows with any certainty what the impacts will be or how soon they will show up.
To add to the confusion, Fed watchers aren’t sure the Fed is actually keeping the schedule it said it would. But if it does, the impacts on interest rates could be significant. To bring inflation back to 2%, the Fed’s goal, the balance sheet would have to shrink by $3.9 trillion, which would amount to about 4.5% in additional rate hikes, said Solomon Tadesse of Societe Generale in the Barron's article. Investors should brace for further volatility.
Fund Managers: Ensnared by Bad Guesses
July was a terrific month for buy-and-hold investors. The S&P 500 staged a 9.1% rally, its best performance since late 2020. But most active managers missed the upswing, stuck as they were in a bearish stance and holding too much cash. According to Bank of America, only 28 per cent of active fund managers focusing on big stocks beat their Russell 1000 benchmarks. All the main styles of mutual funds underperformed — core, growth and value.
The lesson is always the same: if you fail to stay diversified and invested, you will miss the unexpected rallies when they appear. July was a classic example of a short-term rally that active investment managers failed to see coming. By the time they did, it was too late.
Now some managers foresee a combination of steep rallies and steep sell-offs in the months ahead. Who knows? And really, does it matter in terms of your own investment portfolio? Should you be worrying about month-to-month performance? Should you be glued to economic indicators? What about inflation? How much worse will it get? And who can accurately guess the outcomes of so many unresolved global issues, ranging from war to famine to pandemics?
It is popular now to look back in fear at the Volcker era, when sharply rising interest rates led to two recessions in short order. Jeff Sommer (New York Times, 5-August 2022) writes that there are two lessons investors could learn from that turbulent time. First, it was a disaster for “anyone who traded actively and bet wrong on the direction of the markets.” And second, it was “wonderful for those with the patience and resources to ride it out.” He points to the unexpected rally in the S&P 500 we just witnessed: down 20% from January through mid-June—putting stocks into a bear market—only to rebound more than 12%. But that was child’s play compared to the 1980s. Those who hung on from the beginning of Volcker’s term to the end would have seen both exceptional turbulence and enormous gains in their stock portfolio (+215% in the Vanguard S&P 500 stock index) and Treasury bonds (+143% during the same period). In order to have achieved those outcomes, investors would have had to turn their backs on guesswork and fear, and simply let things ride.
Thinking Differently About Outcomes
Lately I’ve been wondering if we are framing the issue all wrong. Maybe it doesn’t take fortitude or perseverance to hang on during tough times. Maybe it only requires common sense and a clear understanding that you can have a plan to manage your wealth and simply revisit it from time to time. It should be a plan that lets you stay invested for the long-term. By trusting both your strategy and pathway, you can navigate market volatility without stress.
Markets are complex and fickle. You have no control over that. Every investment will go in and out of favor from time to time, causing portfolio returns to fluctuate widely. But this should have very little bearing on your peace of mind. Here’s why: We have constructed your portfolio to complement your financial structure, hedge your financial liabilities, and move you toward specific investment objectives with high-confidence outcomes in mind.
Consider that your liquid portfolio is only one component of your total financial structure. This structure includes the totality of your resources such as social security, pensions, real estate, rental income, human capital, insurance payoffs, royalties, businesses, private assets, and possibly inherited wealth. Our approach to wealth management brings all these factors into consideration to build a highly tailored portfolio, taking risk where appropriate to support the precise timing of your essential spending and discretionary objectives.
This is not to minimize your liquid portfolio’s importance. Instead, it is to encourage you to consider it within the context of your entire financial structure. Returns are important, but if you become overly stressed with what the market is doing in the middle of a steep or prolonged downturn, remind yourself that what we are really doing is managing towards outcomes. In other words, immunizing your risk of failure to safely reach the place you are heading, the goals you have set. Periodic returns are just one subset of that total picture.
In the months to come I will communicate more about this issue and how we are prepared to help you think holistically about wealth management. We will also be proposing new ways we can help.
Meanwhile, if you have questions or concerns about your asset allocation, or if your life circumstances have changed in ways that require a portfolio review, please contact me. I am here to help.
July Market Review
Led by the US market, global stocks rebounded in July, a welcome breather for investors after a punishing first half. Better-than-expected corporate earnings and hopes for a slower pace of Fed tightening through year-end contributed to the rally.
The S&P 500 Index soared to a 9.2% return, its best monthly return since November 2020.
All sectors of the S&P 500 Index advanced in July. The consumer discretionary and information technology sectors delivered double-digit gains, while consumer staples and healthcare stocks were the weakest, each up 3%.
US stocks (S&P 500) outperformed international developed market peers in July. Emerging markets stocks posted a modest decline for the month.
June’s inflation data set the stage for a July rate increase. US inflation surged to 9.1% (year-over-year) in June, the largest increase since November 1981. European inflation rose to a record 8.9%, while UK inflation hit a fresh 40-year high of 9.4%.
The Fed raised rates another 75 bps in July, the second consecutive rate hike of that size. Facing record-high inflation, the European Central Bank lifted rates 50 bps in July, marking their first rate increase since 2011.
Despite still-raging inflation and continued tightening from most central banks, government bond yields declined in July. Broad global and US bond indices rallied for the month.
The Bloomberg US Aggregate Bond Index returned 2.4% in July, led by the outperforming corporate bond sector. Treasuries and mortgage-backed securities also delivered gains.
The US Commerce Department reported that the economy shrank for the second consecutive quarter, meeting the traditional definition of recession. Economic concerns pushed the 10-year Treasury yield 36 bps lower to 2.65%. The two-year yield slipped 8 bps to 2.88%, and the yield curve inverted.
Headline inflation climbed to 9.1% (year-over-year), driven largely by soaring energy and food prices. Monthly headline inflation rose 1.3% in June, with the gasoline component jumping 11.2% between May and June.
The Fed responded with another 75-bps rate increase in July, bringing the federal funds rate target to 2.25% to 2.50%. At month-end, fed futures contracts signaled expectations for the Fed to revert to a 50-bps hike in September.
Municipal bond (muni) yields tracked Treasury yields lower. Munis rallied and outperformed Treasuries in July.
TIPS also rallied and were among the top-performing fixed-income sectors for the month. Five-and 10-year inflation breakeven rates climbed higher in July.
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