Vital Questions to Ask In Today's Market
2022 is shaping out to be a challenging year for investors. Investors are currently dealing with the prospect of a recession, stubborn inflation, and higher interest rates. The S&P 500 has been in and out of bear market territory recently (a bear market is a 20% decline from the most recent highs). And to add hurt, the bond markets have also performed poorly year to date.
However, taking action without a solid understanding of the broader market can prove detrimental. Your financial plan should guide action. And monitoring the broader economic and legislative environment is essential to financial planning. Here are vital questions you should continue to ask yourself as you progress through the remainder of the year.
What are current inflation expectations?
Where does Federal Reserve policy go from here?
Is a recession coming?
What are the consequences of increasing interest rates?
What do I do?
What Are Current Inflation Expectations?
If you have been to the grocery store or the gas pump lately, you likely have noticed price increases. From the May 2022 Consumer Price Index (CPI) data, inflation hit 8.6%. This reading represents the highest year-over-year increase in prices for decades. And it appears inflation is broad-based. Prices are up for energy, transportation, food, shelter, and apparel. The chart below illustrates the CPI component's current year-over-year price changes and 12-month peaks and troughs.
So, where does the market expect inflation to go from here? The honest answer is no one knows for sure. But, using the TIPS Breakeven Inflation measure, market participants expect inflation to moderate over the coming five and ten years. However, as you can see from the data, expectations are volatile. This data does illustrate Federal Reserve Policy is driving down inflation expectations, which is a good sign.
Where Does Federal Reserve Policy Go From Here?
The central bank, the Federal Reserve, is responsible for maintaining price stability and full employment in the American economy. With unemployment below 4% but inflation at 8.6%, the Federal Reserve Chairman, Jay Powell, has made it clear inflation is the bank's top concern.
The bank backed up its inflation concerns with action. A mid-month surprise 75 basis point rate hike (the largest since the mid-90s) at the June FOMC meeting solidified the bank's commitment to fighting inflation. Additionally, Fed Chairman Powell's testimony to Congress indicated aggressive rate increases anticipated for July and September meetings. These actions convinced markets that inflation is the priority for the Fed.
Chairman Powell indicated that the current level of inflation would require a short-term rate of at least 3% to get to a neutral level. The Fed funds rate is currently at 1.50%-1.75%. Given the current target, this means several more rate increases this year.
And the data suggests the markets believe Mr. Powell and the FOMC will take action against inflation by increasing short-term interest rates. The chart below illustrates the fed funds' future implied rates. Using market data available in the futures market, we can extrapolate where the market believes rates will be in the future. From the data presented, the market expects rates to increase significantly over the coming second half of this year.
How do interest rates impact inflation? Increasing the cost of money (the amount paid to borrow money) makes it harder for potential capital-intensive projects to be profitable. Think about it. If you spend more and more on interest to build a factory to make widgets, you will make less profit. If a significant portion of profits goes to paying interest on the loan to make those widgets, then it may make the project unprofitable. The idea is that with increasing rates, demand for goods and services will decrease, and thus prices will fall.
A more nuanced and academic argument for combating inflation is to remove cash from the economy by increasing interest rates. If a savings account pays you a respectable amount, you will be more likely not to spend that money and instead put the money into a bank account. This argument relies more on Milton Friedman's assertion that inflation is a monetary phenomenon.
Is a Recession Coming?
"Is a Recession Coming?" seems to be the $21 trillion question these days. More and more data suggest that a recession is in the deck. The following data points indicate a recession is potentially on the horizon.
Equity markets are beyond correction territory.
The yield curve inverted early this year and is flirting with inverting again.
Consumer sentiment is extremely low.
The graph below illustrates how far consumer sentiment has fallen.
Chairman Powell stated, "We fully understand and appreciate the pain people are going through dealing with higher inflation, that we have the tools to address that and the resolve to use them, and that we are committed to and will succeed in getting inflation down to 2%. The process is highly likely to involve some pain, but the worse pain would be from failing to address this high inflation and allowing it to become persistent."
The pain the Chairman is talking about isn't just stock market pain. Fed Reserve actions will likely negatively impact labor markets, which means wage gains may not persist, and unemployment could increase.
As time passes and more data is available, the Fed will likely not successfully engineer a soft landing and avoid a recession. Furthermore, it is hard to determine how long a recession will last if the economy enters one.
What Are the Consequences of Rising Interest Rates?
This year is especially challenging for investors because stocks and bonds have performed poorly. Poor performance is partly driven because of the sudden jump in rates due to inflation. This jump in inflation has simultaneously hurt most asset classes. This year bucks the typical pattern of bonds supporting portfolios under challenging markets. The graph below illustrates stock and bond annual total returns (as measured by the S&P 500 and Bloomberg Total Returns Indexes) going back to 1990.
But new challenges can present new opportunities.
Increased inflation introduces uncertainty into the market, thus often depressing asset values. However, given the lofty valuation of equities earlier this year, stocks are now trading at valuations more aligned with long-term averages. These more moderate valuations can offer an opportunity to purchase equities at a more reasonable price.
In the bond market, bond prices and interest rates are inversely related. So as interest rates increase, bond prices fall. Rising rates can result in a decline in bond values. But the benefit is that purchasing bonds at higher yields can potentially improve future performance.
What to Do?
Focusing on the things you can control is essential. Review spending and consider putting off significant expenses. Consider getting your emergency fund in good shape and focus on saving. We still have six months left in the year, so don't overlook tax advantage saving strategies such as 401(k), education, HSA, or IRA savings. Revisit your expectations.
Stock prices have fallen, so it may be time to take advantage of other tax-saving strategies. Tax-loss harvesting can offset gains elsewhere. If you've been considering a Roth conversion – now may be an ideal time. Lower stock values mean lower taxes, and any growth in a Roth account will be tax-free.
Above all, keep your long-term goals and plan in mind. Managing emotions is a balance of taking a realistic view but keeping your goals in front of you. Don't make reckless moves; focus on the things you can control.
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