The Fed at Back to School Night

By Deron T. McCoy, CFA®, CFP®, CAIA®
Chief Investment Officer

With summer officially over, hurricane season now takes center stage (and of course our best wishes go out to anyone directly affected this season by an actual storm). But our focus here is on potential financial hurricanes. And for the last several months, we’ve been suggesting that an economic hurricane (slowdown or recession) may very well be on the horizon. Why? Tighter financial conditions, higher inflation, and higher interest rates are stressing consumers, reducing consumption, and measurably slowing the economy.Many of us recently had our first back-to-school ‘Parent’s Night’ in a few years. Perhaps it might help to frame the Fed’s current situation in student terms. If a student misses a day of classes, the next day their workload is doubled – as they not only have that day’s homework to do, but also the previous day’s work to catch up on. If they’re out for a week, the task becomes that much harder. And if a student is out for an entire year, both the time and workload required to catch up can feel like an eternity.

That’s precisely where the Fed now finds itself. By missing class (or in the Fed’s case, not paying attention and subsequently failing to tighten monetary policy in the second half of 2021 and the first quarter of 2022), they’ve fallen far behind – making the path and journey back to normalization a long one.

Which is why we were confident the Fed would remain hawkish in August (Jackson Hole) and here again in mid-September – urging investors to ‘fix their roof while its sunny’ after the S&P 500^® soared towards 4300 (topping out at 4283) during the summer rally.

But why?

AUGUST: NO MEASURABLE CHANGES IN THE LANDSCAPE

Did inflation cool in the aftermath of the Fed meetings earlier this summer? In short, no. Even with lower gas prices, higher inflation elsewhere in the economy kept the monthly data point hot. Nothing on the inflation front argued in favor of a policy change.

Many suggested that weakness in stocks or bonds might act as an unofficial nudge to the Fed Chair to change policy. Unfortunately for the doves, stocks remained higher than their mid-June lows – again weakening the argument for a change in policy.

What about debt markets? Did High Yield spreads moved higher; suggesting real stress in the credit markets? Once again, no. Credit spreads actually moved lower from those summer meetings, suggesting credit stress had eased. That was strike three when it came to a policy change justification.

SEPTEMBER: CHANGE IN THE WIND?

But that was August. Finally, September is starting to see changes in the underlying data. Crude oil and gasoline prices are well off their highs. And the supply chain suggests future inflation may also roll over soon (shipping rates from Shanghai to Los Angeles have fallen sharply from when we stated last year, “it’s not a demand problem, it’s a supply chain problem”).

Equities are back down to their June lows, and now bond rates have moved into the 4% range which is higher than some measures of inflation (indicating that rates are finally moving into a restrictive zone).

For the Fed to pivot amid 40-plus year highs in inflation, however, it will need to point to some unequivocal hard data for cover in their quest to restore some semblance of credibility. That data’s not here yet, but it’s coming. We can see it in the soft data now. But for the time being, the 2022 outlook for the Fed (in fact their mandate) remains very much intact – which should continue to slow the economy in the months ahead.

This landscape isn’t permanent (none are). But changes in the hard data are coming. Consider that:

• The Fed will not raise rates another 300-400 percentage points next year. They’re catching up on their late schoolwork, and that work is almost done.
• Valuations are now materially lower and much more reasonable than the last couple of years.
• Remember the acronym, TINA? We can now discuss TARA – ‘There Are Reasonable Alternatives’ in the investment universe with yields now materially higher than the last couple of years. Investment opportunities abound!

Hurricanes are never fun. But they happen. Eventually, however, they fade into memory as hurricane season always eventually comes to an end. The same principle holds true with bear markets. This too shall pass.

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