High Anxiety

The last week of September was bookended by two events that raised market anxiety to cycle highs. First, Liz Truss, the new UK Prime Minister announced regressive fiscal policies that seemed to be working at cross purposes with the UK monetary authorities. The sheer unorthodoxy of bringing stimulative fiscal policy in the form of tax cuts at a time of unprecedented inflation deeply unsettled UK currency (sterling) and government bond (gilts) markets. The diminished confidence in UK policy institutions quickly spilled over to global financial markets.

Second, on September 30, the Federal Reserve’s (Fed) preferred policy gauge, the personal consumption expenditures (PCE) inflation report, delivered higher-than-expected readings. These developments, together with further deterioration of the geopolitical picture surrounding Russia and Ukraine, led to broad turmoil equally in global currency, bond, and equity markets. For long-term investors, anxiety is understandably high as even leadership of the steadfast “60/40”¹ portfolio is in question. Asset class correlations have increased, resulting in both stocks and bonds underperforming in tandem.

Nonetheless, history has repeatedly shown that peak uncertainty rewards the resolve of long-term investors. After holding excess cash for the balance of the year, we are starting to see interesting opportunities emerge. Within equities, we are not yet leaning into risk by overweighting the asset class versus our strategic benchmark, but we are repositioning that risk by rotating out of international developed equities into U.S. large cap. Among more defensive assets—which, admittedly, have not defended this year as we all would hope—we are moving some cash into investment-grade fixed income offering a much more attractive yield than we’ve seen in 13 years.² We expect that coming months may offer additional opportunities to reposition portfolios for the year ahead.

The Fed’s sledgehammer

The Fed is governed by a dual mandate: stable prices and full employment. However, with inflation persistently high, the Fed must choose, and chosen they have. Inflation is the priority, even at the cost of jobs and overall economic growth. Members of the Fed have been very vocal, and they are all speaking from the same script. Hawkish rhetoric has reached a feverish—perhaps peak—pitch.

The Fed’s main monetary policy tool, raising the federal funds rate, is often likened to a sledgehammer. The Fed can control the fed funds rate, but this tool is blunt. That singular policy rate does not immediately or directly affect borrowing costs. Instead, the fed funds rate influences interest rates across maturities and markets, which both drive and derive from decisions by investors, banks, consumers, and businesses. The effects can be lagged.

Like someone who may be attempting a delicate job with a sledgehammer, things can break. There is an increasing risk that the Fed’s actions will in fact cause something to “break,” if not in the real economy, then perhaps in the financial system. In our view, while risks of a recession in the next year have risen, they remain under 50%. We continue to see significant strength on the part of the U.S. consumer, and the U.S. jobs market continues to deliver an expanding base of employment. However, there are a number of imbalances in global financial markets that we must monitor quite closely as the Fed continues its anti-inflation campaign.

 ¹ A portfolio representing a simple mix of 60% equities and 40% bonds, which is a common risk profile in the industry for investors seeking a balance of growth and protection in their portfolio.

² Bloomberg

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