Stocks and bonds fell for the third quarter in a row as investors came to terms with persistent inflation and rising interest rates. Despite a rally early in the quarter, stocks continued tumbling, exacerbating what has been a difficult year. Bonds had a similarly tough quarter, enduring two consecutive 0.75% rate increases by the Federal Reserve on top of the two rate hikes in the second quarter. The Barclays US Aggregate Bond Index fell 4.8%, further deepening what is likely to be the worst year for bonds since the index was created in 1976.
Usually an unexciting topic, inflation now consistently appears as the largest economic problem afflicting the US according to monthly Gallup polls. Some inflation is normal. As the economy grows, rising wages allow consumers to spend more on goods and services. As the prices of goods like phones and cars go up, those items also get better, improving our quality of life.
Over the past century, US inflation averaged about 3% annually but throughout the 2010s, annual inflation averaged less than 2%. Over the past year, prices are up 6%–8%, depending on which index you use to measure changing prices. Because the Federal Reserve uses Core PCE (Personal Consumption Expenditures), we will focus on that index to measure inflation. Core PCE looks at prices paid by consumers but excludes the more volatile food and energy costs. Year over year through August, Core PCE was up 6.2%.
As inflation rises, the money in your bank account falls in value and buys less due to higher prices. Businesses become less likely to invest in growth and hire new employees because they worry their sales will fall if they raise prices enough to account for higher costs. In short, high inflation is very disruptive and contributes to great uncertainty for businesses, consumers and investors alike.
The stock market fell during six of the last seven weeks of the quarter. This painful run started when July’s reports showed inflation fell slightly from June’s highs but not as much as expected. The selloff really accelerated later in August when Fed Chairman Jerome Powell repeatedly used words like “painful” and “restrictive” to describe the Fed’s stance on what it will take to drive down inflation, harkening back to Fed action not taken since Paul Volcker ran the Fed four decades earlier.
When Paul Volcker took over as Fed chairman in 1979, he inherited a 7.4% inflation rate that resulted from increased government spending on both the war in Vietnam and the “war” on poverty at home. This situation was exacerbated by two major energy shocks. This sounds eerily familiar to today, where rising prices were triggered by unprecedented government spending on COVID relief programs, compounded by an energy shock following Russia’s invasion of Ukraine earlier this year.
Volcker believed price stability was vital to a healthy US economy and acted decisively to curb inflation at great cost to the economy and US households. If inflation was being produced by too much money chasing too few products, he would keep businesses and consumers from spending by pushing borrowing costs much, much higher.
One way the Fed controls borrowing costs is by adjusting the interest rate banks charge each other to borrow or lend money overnight. This rate is known as the Fed Funds rate. All other interest rates rise and fall with the Fed Funds rate because banks earn profits by lending to customers at higher rates than the Fed Funds rate.
In the first half of 1980, Volcker quickly pushed interest rates higher, sparking a brief recession. Despite the recession, inflation stubbornly rose to 9.8% later that year, and he took a more at-all-costs approach. The Fed Funds rate was pushed as high as 19.1%, plunging the economy into an even deeper recession in 1981. The average 30-year mortgage rate rose to 18.6%, squeezing many homebuyers out of the market. Factories cut back on production and laid off workers, pushing unemployment up to 10.8%. Whether or not such harsh action was necessary is still debated today but Volcker achieved his goal, leaving a legacy of four decades of falling inflation.
|Historical Cost of a 30-year Mortgage on a $500,000 Loan|
|Date||Average Mortgage Rate||Monthly Mortgage Payment|
|Sept. 30, 2021||3.01%||$2,111|
|Sept. 30, 2022||6.70%||$3,226|
|Oct. 9, 1981||18.63%||$7,793|
When Powell implied the current Fed is willing to take similar action, you can see why markets reacted by selling off sharply. The Fed has raised rates a total of three percentage points in 2022, the fastest the Fed has raised rates at any time since the early 1980s. But at a Fed Funds rate of 3.00% to 3.25%, we are far from a Volcker-like shock and thankfully there are reasons to hope things won’t get to that point.
Despite some cracks, the economy is much stronger than it was in 1979. US GDP fell over the first two quarters of 2022 when adjusted for inflation but is still expected to grow for the full year with growth returning over the second half. Further helping matters, many of the supply shortages that helped spark inflation have worked themselves out and WTI crude oil prices ended September down 39% from March highs.
The Fed has a dual mandate to maintain stable prices and maximize employment. The good news is that the labor market is on firm footing, allowing the Fed to raise rates. Wage growth has been a major driver of enduring inflation over the past year and half. With unemployment at just 3.7% and with 1.7 open jobs for every unemployed worker, wage growth will likely fall back to normal levels before we see widespread layoffs.
Finally, profits of the companies we invest in remain at all-time highs. Earnings estimates have fallen considerably over the past three months but according to FactSet, S&P 500 earnings are still expected to grow 7.4% in 2022 and continue higher in 2023. Also, corporate balance sheets still look strong. Companies may not make as many acquisitions due to higher borrowing costs, but the vast majority of businesses are able to continue growing profits without adding to debt.
At best, we can hope inflation has already peaked. For now, annual PCE excluding food and energy sits at 5.8% as of the end of August, with the highest reading coming in February at 6.2%. PCE including food and energy, which are both part of everyone’s budget, is down to 6.2% from June’s high of 7.0%.
As investors, there’s one more thing to consider about Paul Volcker’s legacy. From when he took office on August 6, 1979, to when he stepped down on August 11, 1987, the S&P 500 earned a stellar 213% return. Far from a smooth ride, stocks experienced selloffs of 10.25%, 17.07%, 27.11%, 14.38%, and 9.42% over that time. Through dark economic times, investors had several chances to sell out, thinking stocks would keep falling. They might have been right in the short term, but time would have proven them wrong.
More than once this year, we have been asked by clients and non-clients why we didn’t sell out this year when we saw Fed policy changing. While that sure would feel better today, we know that markets turn quickly, usually sooner than the economy, and missing out on an early market rebound could be very costly.
There is an investment saying that goes, “If it is in the news, it is in the price.” The fact that the Fed is going to continue raising rates is already in the news and in market prices. Currently, you can earn a higher interest rate investing in one-year Treasury bills (4.05%) than you can in ten-year Treasury notes (3.83%). Generally, the long-term bond is considered riskier and pays a higher interest rate but these yields are saying investors expect today’s higher rates won’t last and that inflation will fall, bringing lower rates over the next ten years.
The bear market will end when the Fed begins thinking about ending rate hikes. Seeing as how estimates of peak inflation have been wrong for the past two years, we’re not going to guess when that will be. What’s important is that it will happen and a new bull market will begin. We’ve already seen four 5%-plus rallies this year that all gave way to new lows. The road ahead will likely continue to be bumpy but investors will be rewarded for patience, as hard as that may be. It’s just a matter of time.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.