Special Market Update: Fed Gets Tougher on Inflation

The Fed’s aggressive 75 basis point rate hike signals its willingness to risk an economic slowdown if that’s what it takes to cool inflation.

June 15, 2022

The Federal Reserve raised rates by 75 basis points today and served notice that it will keep hiking rates aggressively until it sees sound data that inflation is trending lower, and consumers’ rising inflation expectations have been stamped out. 

The sight of May’s consumer price index hitting fresh 40-year highs and the Fed’s expected hawkish response rattled markets, pushing U.S. equities into bear market territory earlier this week. Treasury yields have risen sharply, and the curve has flattened with expectations for a more aggressive Fed. U.S. equities rallied after the Fed’s rate hike announcement, while Treasury yields moved lower on reassuring comments from Fed Chair Jerome Powell that Fed officials are not on auto pilot and remain data-driven and flexible regarding future rate increases. 

Let’s take a closer look at the Fed’s decision, what it may mean for the markets and why investors should expect continued market volatility this summer. 

The Fed’s Decision

In addition to raising the federal funds rate, the Fed also released new economic and interest rate forecasts. It adjusted its year-end headline inflation projection to 5.2%, up from its 4.3% March forecast, and lowered its GDP growth forecast to 1.7% from a previous 2.8%. The “dot plot” of individual Fed governors’ interest rate forecasts suggests an additional 175 basis points of tightening this year as well as a peak federal funds rate of 3.8% in 2023. 

Powell acknowledged during his press conference that inflation has broadened and does not seem to be fading anytime soon. He reiterated that the economy is in sound condition, and so a more aggressive path of interest rate hikes is appropriate to dampen overheated parts of the economy. 

Exhibit 1: Tightening Cycle Expectations: Fed vs. Market 

tightening cycle expectations

What this Means for Markets

The critical question that remains unanswered is whether the Fed will be successful in bringing down inflation without causing a recession. Investors should brace for continued volatility this summer, as the market needs to digest several more months of data to determine how entrenched inflation is, and how long and high the Fed will need to raise rates.

We have long said that the Fed will want to front-load its tightening cycle, and given persistent inflationary pressures we expect to see 50 or 75 basis point hikes at the next two meetings. At that point we may start to see some easing of inflationary pressures and the Fed return to less aggressive rate increases.

While we are not in the recession camp for this year, there are growing concerns of a recession in 2023. We believe that by year-end the fixed income markets could be pricing in a greater chance of a global recession next year. Consequently, we believe the Treasury market could experience a more material inversion of the yield curve, with short-term yields above 3% and intermediate- and longer-term yields closer to 2.5%. An inversion has often preceded a recession by about 6-18 months.

We’ve seen the S&P 500 index’s price-to-earnings multiple (a valuation metric) contract all year as investors price in inflation’s direct hit to earnings. This reset of market multiples may not be over until inflation peaks.

We believe that equity markets could remain bumpy near-term, with continued uncertainty around inflation as well as the potential for negative earnings guidance weighing on stocks. However, the market backdrop could look very different this fall, allowing equity markets to recover. There is the possibility that inflation may then appear to be slowing, simply because its growth will be compared with high inflation prints during the same period last year. Supply chain issues arising from China’s zero-Covid policy may also continue to ease, oil prices could stabilize, and the housing market appears to be cooling. Any and all of these factors could help the Fed take its foot off the brake, giving markets a chance to recover.

Remain Disciplined and Diversified

We continue to advise clients to adhere to a well-thought-out investment plan built around their wealth goals. We took some risk off the table in the first quarter, because of the uncertainties around inflation, Russia’s invasion of Ukraine and the pace of policy tightening. That included taking our equity exposure down to neutral and reducing exposure to high yield credit. Within our small overweight to diversifiers, we also increased exposure to private equity for its low correlation to public markets and more attractive long-term return potential.

We believe a neutral stance in equities is the nimblest place to be in today’s cloudy economic environment. We have used dislocations to add quality by favoring those cash-rich companies that are more able than others to ride through late economic cycles. They include companies in sectors such as energy, utilities, staples and healthcare.

During this particularly volatile time, we have also been recommending buffered equity solutions to clients with excess cash, as a way to step into equity markets with a built-in protection to the downside. Many clients have also taken advantage of lower stock prices to harvest tax losses, which can be used to offset realized capital gains at any time in the future. Customized tax-managed equity strategies are structured to optimize tax-loss harvesting, while still staying invested in the market. Our other Active Wealth solutions, including spending and borrowing strategies are also being used to preserve clients’ wealth.

There remains a lot of uncertainty about inflation and the Fed’s ability to cool price pressures while balancing growth. We expect a volatile summer, especially when second quarter earnings season arrives.

What we do know is that jumping in and out of markets based on emotion can erode longer-term cumulative returns. That’s because the best days often follow the worst days in equity markets. Waiting for the market bottom will be difficult, which is why it’s important to remain disciplined and diversified in order to take advantage of the eventual market recovery.

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