Eight Minutes that Derailed the Bull Market
By some measures, Fed Chair Jerome Powell derailed the fledgling bull market rally in U.S. and global risk assets last Friday. In eight short minutes, the central bank governor drove home the point that the Federal Reserve would do everything within its power to halt inflation, including bringing economic “pain” to U.S. households and businesses alike.
For the markets, it was a halting realization given the fact that the recent market rally had been predicated, at least in part, on the Fed pausing rate hikes and giving the economy some breathing room as various data points have shown that a U.S. recession is looming on the horizon.
But not anymore.
On Friday, Jay Powell briefly laid out a case explaining why it’s essential for the Fed to focus first on inflation, not the economy or the markets. To that end, he ended his speech with a determination to bring inflation back to normal by stating that:
“We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”– Federal Reserve Chairman Jerome Powell, Jackson Hole, August 26, 2022
The Narrative Shift
So, where does this put the markets now? Has the temporary bear market rally finally given way to a broader selloff that could last for months? Or are we experiencing the birth pains of a broad rally in global risk assets?
Well, to recognize where markets may be headed, we often need to understand what can drive prices either higher or lower on a day-to-day and week-to-week basis. And more often than not, markets are driven by a balance between fundamentals and narratives.
So, what’s the difference here? Well, fundamentals look at how the underlying top-down economy could affect corporate earnings and hence, an investor’s overall return on their investments.
When markets are driven by narratives, on the other hand, investors are mainly betting on expectations that fiscal or monetary policies or broad geopolitical developments could affect the overall market direction despite what’s going on in the corporate earnings or the broader economic environment.
Now, while fundamentals are important, it’s likely today that markets are being driven by a broad market narrative.
So, what narrative is driving the markets today? Well, up until Friday, the critical narrative being watched by investors here in the U.S. and around the world was whether the Federal Reserve’s aggressive monetary policy would give way to a more accommodative stance next year. Some have dubbed this the “Powell Pivot.”
Certainly, headline inflation has increased this year, and the Federal Reserve has made some efforts to hike policy rates to curb rising prices. The idea here is that as businesses and households spend less, there will be less demand for goods and services, and hence, prices and inflation could subsequently fall.
So far, the Fed has raised rates four times this year and is expected to do so again at its three remaining meetings in September, November, and December. After that, market expectations had been that policymakers could “pivot”, or stop raising rates and keep them steady, maybe even start cutting interest rates in response to what’s expected to be a recession later this year or early next year.
Now, it’s essential to note that financial markets are in many ways a forward discounting mechanism. As Warren Buffet once put it, “in the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
The rally that we had seen in U.S. risk assets up until last Friday likely had to do with the notion that investors were betting that, even as the economy slows and likely heads into a recession this year, policymakers would likely pivot to a more accommodative stance (like stable or lower interest rates in the coming months).
It’s this narrative-effect that arguably led to the March 2020 rally during the height of the pandemic and also helped juice risk asset prices in 2009 during the Global Financial Crisis, which led to multiple rounds of Quantitative Easing (QE).
So, will they or won’t they?
By some measures, Friday’s Jackson Hole speech was not only disappointing, it in many ways it derailed what had been a time-tested narrative that the Fed would adjust policy to support an ailing economy and hence provide a boost to financial markets. The key takeaway from Jay Powell’s Friday speech is that rescuing the economy is not a priority for policymakers this time around.
Well, keep in mind that the Fed failed to catch the early signs of inflation when it first started accelerating last year. Since then, policymakers have been heavily criticized for calling inflation transitory when in fact, it was more persistent than expected.
From this perspective, Powell and the Fed are trying to save face and make up for a series of policy missteps from last year. Put differently, it appears that policymakers would rather err on the side of being too aggressive and tamp down inflation at the expense of economic growth rather than stopping too soon to save the economy, only to prolong its battle with inflation for years to come. For now, the expectation is that the Federal Reserve will continue to raise interest rates until the end of this year.
So, when will the pain end?
How long rate hikes continue and the magnitude of which will be dependent on incoming economic data. And of significance will be inflation data, and not just headline inflation, but namely the Fed’s preferred measure of inflation, which is PCE inflation, as well as producer prices, energy prices, import prices, and the like.
Put simply, inflation data will be essential to the Fed policy narrative and market direction in the coming months. With headline inflation seemingly turning a corner in July, all eyes will be on the August inflation report due out mid-September to evaluate whether the trend of slowing inflation has some legs.
As it stands today, however, markets still expect the Fed to raise interest rates by 75 basis points at its September 21st meeting and another 75 basis points by the end of the year, bringing the top-end of the Fed Funds rate to four percent!
This rate expectation reflects a more hawkish stance from the Fed combined with the Biden administration’s recent decision to forgive nearly half a trillion dollars’ worth of student loan debt.
Easing Inflation and Shallow Recession Essential to Market Sentiment
So, what does this mean for your investments?
Well, the difference between a short-lived bear market rally and the start of a new bull market likely will come down to how inflation plays out and how resilient the U.S. economy can remain in light of higher interest rates over the coming months.
One area that we’re closely watching as it relates to inflation is housing. Home prices have played a critical role in inflation this year.
For example, shelter makes up nearly a third of the overall CPI basket, and these prices were up nearly 6% on a year-over-year basis in July.
Higher interest rates have nevertheless contributed to weakness in the housing market, which could be a positive development for inflation down the road. For example, existing home sales are down 5.9% from where they were a year earlier, with sales declining for a sixth consecutive month in July. And some real estate firms like Redfin and Zillow are increasingly reporting homes selling for less than asking.
New home inventories have also spiked to levels not seen since 2009 as new home sales have plunged 39% over the past year. In other words, cooling housing market activity could ease rent pressures and subsequently help reduce this key measure of inflation.
At the same time, if energy prices continue to stabilize, agriculture production remains robust and geopolitical tensions in Eastern Europe ease, we could see further positive developments in the inflation story. For now, Friday’s post-Jackson Hole selloff was likely an excuse for traders to take profits after a strong run risk asset rally over the past month.
Nevertheless, we’re likely in for another choppy few weeks in the markets as investors parse through economic data leading up to the September FOMC meeting. At that point, we’ll have a better picture of how pleased policymakers are with the pace of inflation moderation and their willingness to once again support the economy and the markets in the months ahead.
However you cut it, Powell’s eight-minute speech derailed the market’s pivot narrative last week. What investors need now is another broad narrative to support their reason to invest in this uncertain market. Until they do, expect market conditions to remain volatile in the weeks and months ahead.
A Systematic Process for Navigating Market Uncertainty
That’s why it’s essential now more than ever to rely on a disciplined investment process to navigate this period of market uncertainty.
So, what do we mean by investment process? Simply put, we suggest 1) choosing the right mix of assets for a portfolio that aligns with your risk tolerances and objectives, 2) putting money to work in the markets in a disciplined manner, 3) rebalancing portfolios at regular intervals, and 4) finally having a cash management process in place.
Diversify your portfolio
Now, a systematic investment process begins with understanding your own tolerance for risk and adding a set of assets to an investment portfolio that that vary with your overall goals and objectives. What does this look like? Well, for investors with a low tolerance for market swings and a near-term need for access to their assets, a conservative allocation would likely reflect a bias toward more bonds and less stocks.
On the other hand, a more aggressive asset allocation framework could be appropriate for investors who can tolerate wide swings in the markets and have a longer investment horizon. Either way, a solid investment process begins with understanding your preference for risk and your overall investment horizon.
The next part of the systematic investment process involves being disciplined with committing capital to an investment portfolio at regular intervals. As we pointed out earlier, trying to time the best and worst days of the markets might have an adverse effect on overall investment performance. To avoid such issues, we recommend dollar cost averaging, or more simply, committing a set sum of money to your investment portfolio on a regular basis.
What does this look like?
If you participate in an employer-sponsored retirement plan, this could involve setting up automatic payroll deductions and having capital committed to your portfolio every pay period regardless of market conditions. Or, a similar approach can be used for after-tax contributions or lump-sum transfers by scheduling cash allocations to your IRA or taxable investment account on a pre-defined schedule. Either way, putting capital to work at set intervals can help reduce cognitive load, simplify decision-making during periods of market volatility and keep your savings goals on track.
Rebalance your portfolio
Another step in the systematic investment process is portfolio rebalancing. Now, rebalancing is essential because, over time, the values of various assets within a portfolio will drift away from their initial allocations as markets move up and down. The purpose, then, of rebalancing is to realign portfolio holdings with their target allocations.
So, when should you rebalance?
Rebalancing can occur 1) on a set schedule, 2) when asset values drift by a certain threshold, or 3) in a combination of the two. For example, rebalancing on a set schedule could involve evaluating portfolio holdings quarterly, partially selling positions that have appreciated, and adding to allocations that have underperformed during that period.
Alternatively, using a threshold to rebalance could involve using a decision rule that prompts a rebalance only when the value of a specific asset class is a set percentage above or below its target allocation. This process could lead to less frequent rebalancing during flat markets but more rebalancing during periods of heightened market volatility.
Finally, if you’re in the distribution phase of your investment journey, or in other words, dependent on your savings to pay for your living expenses, then cash management is essential for navigating market volatility without missing out on the best days in the market.
Now, a solid cash management technique ensures that you have access to enough liquid assets in your retirement portfolio to cover between 12-18 months of living expenses. Such investments can include money market mutual funds, and the purpose of this approach is to give your savings enough of a runway to avoid having to sell assets at an inopportune time when the markets begin to sell-off.
When it comes down to it, the Federal Reserve and indeed, many central banks around the world have committed to tamping down inflation and doing so at the cost of the economy at large. This means that we’re likely to see heightened economic and market volatility in the months ahead. Put differently, few individuals know which way the economy or markets will be headed in the next week, month or year.
That’s why during times like the present, we challenge investors to ask themselves whether the decisions they are making are aligned with a systematic investment process. This approach includes committing to a target asset allocation framework, deploying capital to the markets in a disciplined manner, rebalancing as appropriate, and having a solid cash management process in place.
Whether you’re looking to buy securities at a discount or avoid losses altogether, there’s rarely a right time to get into the markets. Nevertheless, we believe that staying committed to a disciplined investment process and using techniques to manage uncertainty during periods of heightened market volatility could help you increase the odds of achieving your lifestyle goals regardless of market conditions and keep you on track to mastering your financial independence journey.
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