September 22, 2022
Some thoughts on the Federal Reserve and Jerome Powell.
The September meeting of the Federal Open Market Committee has given me some new information. Chairman Powell has gotten more aggressive in his rhetoric and the rest of the committee seems to be getting more aggressive as well. The statements that demonstrate this to me are:
· “Clearly today we’ve just moved into the very lowest level of what might be
restrictive and certainly in my view, and the view of the committee, there’s a
ways to go.”
· Powell says it is “likely” that the Fed does take the policy rate to 4.6% as
projected in the median estimate of policy makers.
I am not sure why the Fed kept rates so low in 2021, but they did. We (along with many others) pointed out the risk of higher inflation back then and significantly underweighted bonds because of how high the risk was relative to the returns. Perhaps the chairman is now embarrassed about how wrong Fed policy was, and now he and the committee are overcompensating. The Fed is getting more aggressive at a time when growth and inflation seem to be slowing. Normally a central bank wants to be counter cyclical. But, whatever the reason, I am paying close attention to their intentions and what it means for the market. It is important to recognize that higher rates will likely create more volatility in longer duration assets like the stock market.
I suspect a new Federal Reserve mistake is in the making, and this creates new opportunities. I still believe that noise in demand/supply due to Covid is the primary culprit when it comes to higher inflation. I do not believe inflation is “entrenched” in the economy. So, although it is very high at the moment, I suspect growth is slowing and inflation will start falling (as I pointed out in my early September commentary on our website).
The good news is that the two-year treasury yield (at the time of my writing) is approximately paying a US government guaranteed return of 4.11%. This is approximately 400bp higher than it was at the middle of 2021! It is a huge change! So, although I believe firmly that equities will outperform over a longer time horizon, we will continue to add fixed income at attractive yields while volatility is high. On the margin, and in the short term, this will reduce volatility in our portfolios (further) relative to the market.
As always, your portfolio remains well diversified to reflect uncertain outcomes. Although asset prices have declined in just about every sector and geography (perhaps conjuring up negative emotions) in the short run, I continue to be very constructive on the long-term prospects for the US and global economy. As the facts and probabilities change, our portfolios change to reflect the opportunities.
We focus attentively and consistently on your ability to tolerate short term changes in your asset values (because of volatility) that inevitably occur, because of its importance in contributing to the long-term performance of remaining invested throughout difficult times.
My colleague Peter Grave has put together an excellent piece (below) on why it is so important to remain invested throughout time.
Peter Grave: September 22, 2022
Volatility is a normal part of investing. Market corrections in the short term can be unsettling, but they occur regularly, and they should not be surprising. As our principal, Joseph Cardello, regularly points out, we accept market volatility in the short-term in order to allow time and compounding to work for us in the long-term. We also use short term volatility to opportunistically increase and/or decrease risk across asset classes, geographies, and time.
For many investors, the most meaningful measure of volatility is the intra-year decline in equity markets. This represents the largest drawdown (and usually the greatest emotional discomfort) an investor will experience during the year.
According to Fama/French, from July 1st, 1926, to December 31st, 2021, after a 20% decline in the market as measured by the Fama/French Total US Market Research Index Returns. The cumulative return on average is:
· After 1 year +22.2%
· After 3 years +41.1%
· After 5 years +71.8%
[1} Market declines or downturns are defined as periods in which the cumulative return from a peak is -10%, -20%, or -30% or lower. Returns are calculated for the 1-, 3-, and 5-year look-ahead periods beginning the day after the respective downturn thresholds of -10%, -20%, or -30% are exceeded. The bar chart shows the average returns for the 1-, 3-, and 5-year periods following the 10%, 20%, and 30% thresholds. For the 10% threshold, there are 29 observations for 1-year look-ahead, 28 observations for 3-year look-ahead, and 27 observations for 5-year look-ahead. For the 20% threshold, there are 15 observations for 1-year look-ahead, 14 observations for 3-year look-ahead, and 13 observations for 5-year look-ahead. For the 30% threshold, there are 7 observations for 1-year look-ahead, 6 observations for 3-year look-ahead, and 6 observations for 5-year look-ahead. Peak is a new all-time high prior to a downturn. Data provided by Fama/French and available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Fama/French Total US Market Research Index: 1926–present: Fama/French Total US Market Research Factor and One-Month US Treasury Bills. Source: Ken French website.
Declining equity markets will have an impact on your portfolio, but the magnitude of that impact is often determined by your ability to stay invested or your decision to sell at the wrong times. Investors often sell when prices are down which has a detrimental impact to your portfolio growth over time. The chart below from JPMorgan shows how performance suffers when emotion drives a decision to sell.
It's also worth drawing attention to the performance of various asset classes over the past twenty years in the JPMorgan chart below. This proxy for the performance of the average investor over the period was significantly worse than most other asset classes.
It is also worth pointing out that inflation was running at 2.2% and cash at 1.2% during the last 20 years, but now inflation is higher and cash deposit rates are lower.
Protecting your purchasing power is of the utmost importance. Holding excessive amounts of cash erodes wealth over time. That is why it is important to maintain a long-term investment strategy tailored to your family’s goals and within your risk tolerance.
Joseph Cardello, Principal August Wealth Advisors, LLC 51 Riverside Avenue, First Floor Westport, CT 06880 Direct (916) 461-9451 toll free (800) 985-9477
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