Financial conditions continue to tighten, but perhaps not fast enough. Job creation remains strong and consumer spending and inflation are running hot, so the Fed accelerated its rate of interest rate increases, hiking by 75 basis points at its June meeting.
The U.S. Federal Reserve met in a particularly chaotic period for financial markets and delivered a 75 basis point (bps) interest rate hike. While a 50 bps hike had been expected as recently as Monday morning, last week’s elevated inflation report and resulting market turmoil led the Fed to take things up a notch. The federal funds rate target range now stands at 1.50% - 1.75%, but it seems certain to travel significantly higher at the next meeting.
The Fed also published a forecast showing that the median Federal Market Open Committee (FOMC) voting member has become more pessimistic about bringing down inflation quickly without an increase in unemployment. The median forecast now has gross domestic product (GDP) growth falling to 1.7% from 2.8% in March and calling for a rise in the unemployment rate to 4.1% by the end of 2024 (the current level is 3.6%). The Fed now expects core personal consumption expenditures (PCE) inflation to be a little higher for 2022 than it did back in March.
In his press conference following the meeting, Fed Chair Jerome Powell outlined the committee’s goal as bringing inflation down to 2% while preserving a strong labor market. But he acknowledged that factors beyond the Fed’s control – commodity price increases and supply chain issues – may make that challenging.
It’s too darn hot
Inflation has not moderated as much as either the Fed, the market or, frankly, we expected it to over the first five months of the year. This is largely because the ongoing war in Ukraine has pushed up prices of goods and services that are sensitive to food and energy costs. This includes gasoline, but also core services like airfares.
While goods like furniture and appliances are now experiencing disinflation or outright deflation, this has been more than offset by a broad-based rise in service prices. Service price inflation, which includes rent, covers most consumer spending and is often more persistent than goods price inflation.
Both the Fed and the market recognize that tighter financial conditions are required to dissuade employers from hiring and raising wages, effectively short-circuiting any budding wage-price spiral. Data showing falling job openings and softening wage growth are, therefore, welcome at this time.
Market jitters have returned
Core inflation seems to have peaked in the U.S., but rising energy prices may make the next few months feel more like a plateau than a decline. Markets have priced in significantly more tightening from the Fed, and the Fed itself sees rates rising to a 3.25% - 3.50% range by the end of this year.
Investors have priced in a high probability of another 75 bps rate hike at the July meeting, with hikes of declining magnitude expected over the balance of the meetings in 2022 and into 2023. We expect the data between now and the end of the summer – on job openings, wage growth and other measures of price inflation – to help bring those rate expectations down a bit further. Consider that we are not yet two weeks removed from a May jobs report that showed strong job creation, an expanding labor force and moderating wage growth. Market sentiment can change very quickly.
Futures pricing coming into the meeting had the federal funds target rate topping out at close to 4% in mid-2023. But the Fed should not have to hike quite so far with the moderate slowing in the labor and housing markets already underway. We expect a relatively rapid series of interest rate increases continuing until the Fed reaches around 3% at the end of this year, followed by a pause. The 10-year U.S. Treasury yield also seems likely to settle down into that range, as the yield curve remains flat.
Somewhere to run and hide?
As investors are well aware, market conditions have not been friendly to diversified portfolios in 2022. Both stocks and bonds have struggled to generate positive returns except over very brief periods, with volatility – an oft-used euphemism for “losses” – particularly pronounced over just the past week. But we still believe the U.S. economy will avert disaster even as policymakers press harder on the brakes to stop inflation, and we have turned our attention to a number of potential opportunities.
First, municipal bonds have been whipped around by interest rate volatility as much as, if not more than, any other asset class, but credit fundamentals for state and local governments remain quite strong in the wake of the pandemic. While we would wait to meaningfully extend duration amid the ongoing curve tumult, investors can pick up attractive tax-exempt yield across maturities and credit ratings.
Equities have also not been a target-rich environment, to say the least, with the S&P 500® Index plunging definitively into a bear market earlier this week. Even energy stocks, 2022’s standout performer, are down more than 8% from their peak earlier this month. Slower economic growth now seems inevitable, even if a recession can yet be avoided. We are allocating more to areas of the market that benefit when growth becomes scarce, mainly in the technology sector. Investors wishing to be even more defensive can consider utilities or consumer staples, but many already trade with a significant valuation premium given their history of outperforming during bear markets.
Real assets offer income, defensive properties and often a hedge against inflation, which would seem to make them ideally suited for today’s environment. But investors must be discriminating in their selection. TIPS, for example, often perform well when inflation expectations are rising, but investors can lose money when actual inflation is high and the Fed is aggressively tightening.
Gold and other “dollar substitutes” also seem good in theory to offset inflation and devaluation, but they have not kept up with the surging U.S. dollar as markets price in higher rates.
Real estate and other real assets, like farmland and timber, can be difficult for some investors to access. But they afford many of the benefits investors seek – income and inflation resistance – without the daily volatility that more liquid assets often feature.