Economic Flash: Rising Rates Return
September 2022
US Economy: Less pain at the pump.
Cracks are showing in areas that mark a weakening economy. Notably, there is weakness in personal spending, durable goods orders, and most real estate data. However, consumer confidence rose for the first time in 4 months as the average price of gasoline nationally tumbled to $3.84 from over $5.00 and inflation showed signs of moderating.
US Stocks: Tech belt-tightening.
August saw the return of several equity market trends in place prior to July. Energy (+2.8%) and utilities (+0.5%) were the only positive sectors, whereas growth-oriented sectors such as technology (-6.1%) were among the laggards. Tech heavyweights Apple, Alphabet and Amazon each plan to curtail hiring due to inflation and economic growth concerns.
Foreign Stocks: EM strength.
Returns in emerging markets rebounded in August. India (+4.4%) and Brazil (+7.0%) lead amid Covid recovery and higher natural gas prices/easing political concerns, respectively. That said, China’s dogged pursuit of a Zero-Covid policy continues to pose a risk to global growth and supply chains, most recently restricting the movement of 65 million people in 33 cities.
Fixed Income: Fed’s hard stance.
The Fed’s stated goal is to bring inflation back down near 2%, suggesting ongoing interest rate hikes despite “some pain” for the economy. The yield on 10-year US Treasuries rose to 3.2% in August, even as inflation expectations for the next 3 and 5 years fell to 3.2% and 2.3%, respectively, while the most economically sensitive equity sectors are down dramatically (a leading indicator).
Real Assets: Commodities disparate.
Commodities led real assets that are more inflation-sensitive, but not all contracts benefited. Both industrial (-2.7%) and precious metals (-4.9%) suffered on weakening global demand and the rising U.S. dollar respectively. Meanwhile, agricultural (+3.6%) and soft commodities (+8.4%) surged with extremely hot weather and supply chain disruptions a tailwind for each.
Alternatives: Hedge funds outpace.
With limited exception, hedge fund indices showed uniform, incremental gains. Such alternative strategies performed relatively well as inflation and interest rate concerns contributed to elevated volatility while M&A activity picked up moderately. In this environment, CTA/Managed futures strategies (+3.3%) performed well as did the Event Driven category (+2.1%).
Equities Total Return
| AUG | YTD | 1 YR | |
|---|---|---|---|
| U.S. Large Cap | (4.1%) | (16.1%) | (11.2%) |
| U.S. Small Cap | (2.0%) | (17.2%) | (17.9%) |
| U.S. Growth | (4.4%) | (23.1%) | (19.4%) |
| U.S. Value | (3.0%) | (10.0%) | (6.5%) |
| Int’l Developed | (4.7%) | (19.6%) | (19.8%) |
| Emerging Markets | 0.4% | (17.5%) | (21.8%) |
Fixed Income Total Return
| AUG | YTD | 1 YR | |
|---|---|---|---|
| Taxable | |||
| U.S. Agg. Bond | (2.8%) | (10.8%) | (11.5%) |
| TIPS | (2.7%) | (7.5%) | (6.0%) |
| U.S. High Yield | (2.4%) | (11.0%) | (10.4%) |
| Int’l Developed | (5.9%) | (21.9%) | (25.6%) |
| Emerging Markets | (0.9%) | (9.4%) | (10.5%) |
| Tax-Exempt | |||
| Intermediate Munis | (1.8%) | (5.7%) | (6.1%) |
| Munis Broad Mkt | (2.5%) | (9.2%) | (9.1%) |
Non-Traditional Assets Total Return
| AUG | YTD | 1 YR | |
|---|---|---|---|
| Commodities | 0.1% | 23.6% | 27.7% |
| REITs | (6.2%) | (18.6%) | (13.7%) |
| Infrastructure | (1.5%) | 1.9% | 5.2% |
| Hedge Funds | |||
| Absolute Return | 0.5% | (1.4%) | (1.4%) |
| Overall HF Market | 1.2% | (3.4%) | (3.7%) |
| Managed Futures | 3.6% | 21.7% | 21.3% |
Economic Indicators
| AUG-22 | FEB-22 | AUG-21 | |
|---|---|---|---|
| Equity Volatility | 25.9 | 30.2 | 16.5 |
| Implied Inflation | 2.5% | 2.6% | 2.3% |
| Gold Spot $/OZ | $1711 | $1909 | $1813.6 |
| Oil ($/BBL) | $96 | $101 | $73 |
| U.S. Dollar Index | 123.2 | 115.3 | 113.1 |
Our Take
In August, financial markets gave back a fair share of July gains as sentiment shifted pessimistic on inflation and interest rates. While it was certainly nice to see inflation cooling off a bit as the year-over-year CPI fell from 9.1% to 8.5% and the Fed’s preferred metric, the Core PCE Index, fell from 6.8% to 6.3%, those figures remain well above the Fed’s objective of 2.0%. In July, investors were optimistic that a softening in consumer spending and real estate data would deter the Fed from raising rates too far too fast at the expense of the economy.
However, positive sentiment faded in August as interest rates resumed their rise and Chair Jerome Powell underscored that the Fed will do whatever it takes to bring down inflation. At the end of last year, we identified Fed policy error as one of the greatest risks to financial markets and the economy and that remains the case. With Powell’s comments in hand, and the intent of the Fed’s actions clear, it now seems more correct to say simply “Fed policy” is a major risk.
While you will rarely find us willing to try and pin the tail on the donkey in the economic realm, we are constantly evaluating the range of market and economic possibilities. Top questions on investors’ minds: How high will interest rates go; and how quickly can inflation come down? The US Treasury yield curve provides some insight on both.
On interest rates, the currently inverted yield curve indicates that anticipated hikes in the Fed’s key interest rate have already driven short-term rates higher: The 12-month T-bill currently yields more than 4%, much higher than the Fed funds rate of just under 2.5%. Meanwhile, the fact that yields on intermediate and longer-term bonds are lower than on short-term debt suggests a market consensus that weaker growth and falling inflation are likely to pull interest rates back down over the following handful of years. Of course, markets, like tea leaves, can and often do get things wrong.
Toward Inflation 2.0%
Clearly, inflation has turned out to be less transitory than expected by many economists. That said, some of the less structural elements of the rise in inflation have moderated and suggest inflation will come down, albeit slowly. The falling price of gasoline (down 9.5% since June) due to the strong US dollar and weakening global demand was the predominant factor in cooling inflation for July and August. Still, even if inflation does begin to cool meaningfully it appears that path could remain above the Fed’s target over the next few years, which is a meaningful portfolio consideration and warrants continued emphasis on inflation-benefiting real assets.
Ultimately, the data we get in the coming months on inflation, economic fundamentals and corporate earnings (which have been trending down) will be critically important in clarifying the economic and investment landscape. Until then, uncertainty regarding the speed and magnitude of future rate hikes versus material signs of slowing growth/inflationary pressures will likely make volatility a constant. Testing of the June equity lows is an increasingly common refrain in the financial press. While this type of environment can cause anxiety over portfolio positioning, if we have done our job of building portfolios with a long-term foundation correctly, this is a time when we can add value as dislocations present new investment opportunities. Remaining emotionless and disciplined when markets test your resolve should be kept top of mind as we head into September, historically the worst month of the year for the S&P 500.
