Powell’s Jackson Hole Speech Emphasizes Inflation Fight As Investors Realize Rates Must Head Higher
In September, the Dow Jones Industrial Average fell 8.28 %, the S&P 500 dropped 8.63 %, and the Nasdaq sunk by 9.07%. For the third quarter, the Dow lost 7.63%, the S&P 500 gave up 6.27%, and the Nasdaq retreated by 4.96%.
Over the first nine months of 2022, the Dow, S&P 500, and Nasdaq are down 20.95%, 24.77%, and 32.40% respectively. Like a pelican repeatedly diving to snare a fish, investors similarly have been burned by believing Fed Chairman Jerome Powell will stop raising interest rates.
With the Fed’s credibility in question, Powell’s Fed knows inflation is too high (above 8%) relative to the current Fed Funds rate. At this rate goes up, the value of most financial assets goes down. Repeat. Rinse. Lather. Interest rates up, financial assets down. Historically, the biggest mistake the Federal Reserve made was not addressing a dramatic rise of inflation with interest rates commensurate with the increase. It took place in the 70s and early 80s, and high inflation took over a decade to calm down.
The current Fed is trying to avoid the same policy error by committing to raise interest rates to manage inflation. With three consecutive seventy five basis point increases, the slow and steady water torture for investors has been unrelenting on the decline in financial asset value. With markets traditionally forward looking six to twelve months, the market sell off has most high-profile economists calling for an impending recession. Indeed, when chairperson Powell says in his press conference many Americans may “feel some pain” in the effort to quell inflation, higher unemployment and slower growth are the specifics he is referring to. There is discomfort in the lower value of portfolios across the land.
In some parts of the economy, participants argue the country is already in recession. Certainly, in real estate and housing, with mortgage rates piercing 7%, transaction volumes have dropped off a cliff. Oil prices have reacted to the recession drumbeat with the price down to below $90 per barrel of (Brent). The consumer remains in solid shape with debt levels low and balance sheets holding plenty of cash. Retail sales numbers have held up well, but the real pain is all along the financial services area. Investment banking transactions and IPO’s have been virtually nonexistent all year. Trading volumes for the fixed income area have been strong, along with volatile currency markets, led by the unending strength of the dollar.
As for equity markets, the key question is what happens with inflation? Many believe housing costs are misrepresented in the consumer price indexes which comprise inflation data. As such, inflation readings will remain elevated for the next six months because of the heavy housing weighting in the index (nearly 35%). If so, Powell will keep hiking, and we know what that has meant. Still, with the bear market firmly entrenched, lower prices typically mean high returns in the future, the question being when?
Pound and Yen Weakness Show Impact of Rising Rate Environment
2022 has been a tough year for global equity markets, with the prime factor the rapid increase of inflation around the world. Inflation leads to higher interest rates, and subsequent volatility in fixed income, currency, and equity markets. Across global equity indexes, the typical country index has lost 15-25% of its value, depending on country specifics of GDP growth, inflation, and interest rates, along with the government policies enacted. Let’s take a closer look at why the idea of relativity is important in the current market.
We are all familiar with the saying “It’s all relative.” Essentially, looking at anything absolutely doesn’t give a complete picture. By comparing like items, a more accurate depiction is achieved. In finance, the same holds true. We know in the current stormy financial environment; the Federal Reserve has raised interest rates three times by seventy-five basis points. Some central banks have followed the Fed’s lead, others have not. The prime examples are the Bank of Japan, which hasn’t increased rates, and the Bank of England, which has, but only by increments of twenty five and fifty basis points, reaching 2.25%. The United States Fed funds rate is now 3.25%. The higher U.S. rate relative to the UK has caused a dramatic fall in the value of the pound from $1.40 per pound to $1.05. The same situation holds true in Japan, but for the first time in decades, the Japanese central bank has stepped into the currency market to support the yen and sell dollars. For investors, higher relative levels of interest rates clearly raise volatility across global capital markets. The volatility in currency and bond markets spills over into equity markets. Understanding these dynamics may prove even more important over the next few months, years, and decades.
The Art of Contrarian Thinking: Forced Sellers Are Moving Markets and How to View the Current Market
Let’s face it: owning stocks over the last year has been tough. With equity markets down over 20%, the loss of value is difficult to stomach. Even more concerning are the wild swings which take place on a daily, weekly, and monthly basis. Why does it happen? Historically, the irresponsible use of leverage, or borrowing, is the culprit. Hedge funds, long only funds, long short funds, and short only funds can borrow capital to help improve returns. However, what can help may also prove destructive when markets go against the investor.
Investment banks have entire businesses, called prime brokerage, set up to provide borrowing for these entities. It is one reason interest rates are so important in financial markets. Borrowing is used more extensively in the bond market, as well as currency markets. Currency markets allow for fifty times leverage of equity capital to be borrowed for investment (put in $5,000, borrow up to $250,000 for use). Depending on the client, bond investors can also employ plenty of leverage (typically around 300% of equity).
With interest rates below 2% for over a decade, the rapid increase in rates over the last year has caused tremendous volatility in both the bond and currency markets. What are the two markets which employ the most leverage? Bonds and currencies. If a fund has employed a great deal of leverage to invest in stocks, bonds, and currencies (or some combination), and positions have moved against them, prime brokers often require more capital in the account, known as a margin call. This is what transpired in 2008 and the current market dynamics have a similar feel. There is a very high probability the same thing is taking place today. Funds have to sell their best and most liquid stocks to cover losses in other places, especially those employing high leverage. According to FINRA, at the start of 2022, $910 billion of margin debt was employed across U.S. markets. Today, the total is down to 688 billion. Those are b’s, not m’s. They do not include global margin totals. With all the volatility taking place across the globe, especially in the bond and currency markets, liquidations are being forced. It will take time to discover the guilty parties. How does one benefit from their risk management deficiencies?
My recommendation is target companies you want to own and understand why you want to own them. There are plenty of enterprises trading at decade level lows which could prove quite beneficial to own for years to come. If you are nervous about the markets heading lower, dollar cost averaging is a good way to systematically plan for a lower market over the next few months. Don’t use leverage, stay positive, and own companies you believe in and can depend on. I hope this helps you think about what is currently taking place in capital markets across the globe.