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Navigating the Economic Crossroads: Fed’s 11th Rate Hike and Its Impact on Investments in 2023

To no one’s surprise, the Federal Reserve raised short-term interest rates again during their July meeting. This was their 11th increase since the spring of 2022. As expected, the Fed Funds rate went up 25 basis points, or a quarter of 1 percent. The new rate is 5.25%-5.50%.

What remains unclear is whether this is the last interest rate increase for the current tightening cycle. If inflation continues to come down to the Fed’s 2% target, then it probably is. However, we won’t know until the end of the year because Federal Reserve Chair Jerome Powell will most likely keep his options open and the markets guessing. Rate decisions will be data-dependent, primarily on the monthly unemployment, PCE and CPI numbers. The great news is that inflation has improved from over 9% annually in the spring of 2022 to 3% today, so interest rate increases have worked to bring down inflation. 

As a result of this improvement in inflation, there is now a lot of discussion that we won’t have a recession in 2023 and Powell will have accomplished a “soft landing” that no one expected as recently as a few months ago.

READ: Finding the Silver Lining Amidst Rising Interest and Inflation Rates

So, what does this mean for investors investing in the stock and bond markets?

Stock Markets

The rally in the stock market in 2023 is reflecting a Goldilocks economy: not too hot, and not too cold. This rally began in earnest right after chip maker Nvidia released their blockbuster earnings report in May. This ignited a massive rally in AI and technology stocks. However, over the last month, this rally has broadened out to other sectors of the market, which is what is needed to keep the new bull market alive. Whether this can continue will depend on corporate earnings, inflation, and interest rates. So far, so good.

As I mentioned in my June article, there are other sectors of the stock market that are attractive. Dividend-paying stocks in the healthcare, financial, energy and industrial sectors look inexpensive compared to AI and technology stocks. Even international stocks are attractive and are trading at an average price-earnings ratio of 13 versus the S&P 500 Index Fund with an average PE ratio of 23.

Bonds & Money Market Funds

For investors who don’t want to buy stocks, bonds are a good alternative once again. Riskless short-term treasury bills yield 5.5%; money market funds and investment-grade corporate bonds pay 5%. If investors want to take more fixed-income risk, they can buy high-yield bonds that pay over 8%. Bond yields haven’t been this favorable since 2008 and the financial crisis.

The Fed will meet again September 19-20. Today the stock market is telling us there will be a soft landing in lieu of a recession, and no more interest rate increases for the rest of the year. It is difficult for investors to trust these rosy scenarios, jump on the bandwagon and chase this rally, particularly if they have been sitting on the sidelines. We could see a serious case of FOMO (“fear of missing out”) by the end of the year, and this is like adding gasoline to a fire.

Investors tend to hate watching the markets go up without them. This is why market timing is impossible. As our Beacon Pointe Chief Investment Officer likes to say, volatility is the price we pay to make money in the markets. However, if these three assumptions are wrong, whatever positive gains we have seen so far this year could evaporate. Being an investor is not easy.

 

Thumbnail Fred Taylor HeadshotFred Taylor is a Partner, Managing Director at Beacon Pointe Advisors, LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed. Past performance is not a guarantee of future results. Beacon Pointe has exercised all reasonable professional care in preparing this information. 

Does an Inverted Yield Curve Portend a Recession?

The last time I wrote about the bond market was five years ago when interest rates were about to become inverted. When this happens, it simply means you can get a higher interest rate on a shorter maturity bond than on a longer maturity bond. For example, if you wanted to buy the 2-year Treasury bond today, the government would pay you 3.18% in interest. If you wanted to buy the 10-year Treasury bond, you would only get 2.95% in interest. Doesn’t make sense, right? Why would you tie up your money for an additional eight years and receive less in interest? You wouldn’t — unless you think a recession is coming. Guess what? The bond market is now predicting a recession. In fact, we may already be in one.

Today, bond investors think the Federal Reserve’s recent aggressive interest rate hikes will slow down the economy enough to throw it into a recession. We have already seen mortgage rates jump from 3% to almost 6% in the first half of 2022. This means numerous first-time homebuyers may not qualify for a new home. Interest rates on auto loans and credit cards are much higher, too. Anybody who borrows on margin from their brokerage account is paying an extra 2-3% from just a year ago.

These higher interest rates are going to make things a lot less affordable. If things get too expensive, consumers will think twice about making purchases. We are also starting to read about layoffs from the big tech companies in Silicon Valley and a slowdown in hiring on Wall Street. With unemployment at an incredibly low 3.6%, companies will ultimately need to lay off workers to maintain current margins and profits.

If the recession gets bad enough, the Federal Reserve will eventually have to cut interest rates to stimulate the economy. The irony is the Federal Reserve needs to raise interest rates high enough to kill inflation, slow down the economy, and cause higher unemployment, only to turn around and start cutting rates again. This interest rate cycle may take the next 3-12 months. In the meantime, investors in the stock market, homeowners, and workers will likely suffer.

Inverted yield curves are rare occurrences, which is why investors and the media pay such close attention to them. It happened in 1991, 2002, 2008, and most recently (and briefly) in 2020. There is also a very strong correlation between recessions and bear markets. We had bear markets in 1991, 2002, 2008, and in 2020. The difference this time is we are already in a bear market. Let’s see if the inverted yield curve is right: a recession might be just around the corner.

 

Thumbnail Fred Taylor HeadshotFred Taylor is a managing director and partner of Beacon Pointe Advisors’ Denver office. He helps individuals and families build wealth, live off their wealth and leave a legacy for future generations. A former economic advisor to Governor Bill Ritter, Fred has more than 35 years of financial services experience.

 

Important Disclosure:
Frederick Taylor is a Partner, Managing Director at Beacon Pointe Advisors, LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed. Past performance is not a guarantee of future results. Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified or attested to the accuracy or authenticity of the information. The discussions, outlook, and viewpoints featured are not intended to be investment advice and do not consider specific investment objectives or risk tolerance you may have. All investments involve risks, including the loss of principal. Consult your financial professional for guidance specific to your circumstances.

The “American Rescue Plan” will bring a return of inflation

With the passage of the $1.9 trillion relief package, prominent economists are expressing concern that the risk of inflation may now move even higher.

“There’s a real possibility that within the year, we’re going to be dealing with the most serious incipient inflation problem that we have faced in the last 40 years,” said former Treasury Secretary Larry Summers.

At a minimum, the fear of inflation is front and center of the current economic discord. The questions that come to mind are: Will we have it and when? How will it impact us? How much inflation are we likely to see? Was this even considered prior to the approval of one of the largest stimulus packages ever? These questions give investors and consumers angst; after all, inflation is rarely a good thing.

When the costs of the goods and services we buy every day are increasing, our income needs to grow, preferably at a rate higher than inflation. Inflation is like a headwind everyone faces; you may not feel it daily, it is subtle. Over an extended timeframe it is powerful.

Bonds or fixed-income investments are impacted the most during times of rising interest rates. A bond essentially promises to pay an interest rate and repayment of the loan at a particular time in the future. You bargain on the rate and the maturity date and receive fixed payments for the bond’s life. The trouble with that approach is the “fixed” part. Fixed cannot and does not increase over time.

Furthermore, when interest rates rise relative to the rate of your bond, the market value declines. Investors are about to see this in their investment statements as interest rates have risen dramatically recently. The U.S. Treasury 10-year bond has risen from 0.50 to 1.50%. People will look at their bond holdings, either mutual funds or individual bonds, and likely see their prices have fallen. Most people think bonds are “safe.” They are about to get a lesson in fluctuations they thought only applied to stock investments.

Investing in the stock market can be a great way to hedge against rising inflation. Since 1929, the stock market has gained around 9% per year while inflation averaged about 3% per year. Combine this approach with a strategy focused on dividend-paying companies, and you have a practical method for growing income that outpaces inflation.

Over the last 93 years, dividends have grown roughly 5% per year, and corporate earnings have grown at 5% per year. The price you pay for this approach is increased volatility. The price of stocks tends to swing more widely than bonds, but this is irrelevant for long-term investors and especially those who live off dividends.

It is critical to note that people do not live on their investments’ current price; rather, they live on the income generated by their investments. Individuals don’t spend the value on the statement; they spend the dividend income.

The other hedge we often hear about is gold. The challenge with gold is it is difficult to handle, divide, or use for anything other than speculation. You buy gold at a specific price and hope to sell it to someone else at a higher price. It is price speculation. It does not pay a dividend; instead, if you have someone hold your gold, you pay a custody fee. That’s a reverse dividend! You pay them to hold it for you. It does not generate income; it costs you to keep it.

Given our current environment, investors are wise to position themselves with ample cash (generally risk-free) and invest in businesses that will grow their dividends and earnings during a time of rising inflation. It may seem odd to think about cash as an investment class, but cash will conserve your principal during a time of rising interest rates while bonds will experience declining price or value. Blending a long-term asset class like stocks with cash in a portfolio can make a decent hedge against inflation.

While we can’t state with certainty that our economy will experience runaway inflation, many knowledgeable economists have foreshadowed it. No one knows for sure; however, we expect to see financial service companies and product manufacturers create products that are “designed to protect” investors from the ravages of inflation. Products like this are often complex and confusing. Simplicity often is a good strategy.

Invest in growing dividend companies and keep your cash reserves higher. If the U.S. experiences the predictions of rising inflation, financially this could be a better option than buying or holding bonds.

Securities offered through LPL Financial, Member FINRA/SIPC.

Steve Booren Photo Steve Booren is the Owner & Founder of Prosperion Financial Advisors. Steve Booren founded Prosperion Financial Advisors in 1996. Since then, he has grown the practice to one of the top 20 largest financial advisory firms in the Denver area. Utilizing his 40+ years of investment experience, Steve authored the book, Intelligent Investing: Your Guide to a Growing Retirement Income, in 2019, and is a frequent contributor to The Denver Post on financial topics.