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The Consumer Price Index (CPI) rose less than expected in July, which sparked a massive rally in equity and bond markets. The takeaway was that the worst of inflation was behind us, and because of this, the Federal Reserve was likely to slow their pace of interest rate hikes. Markets were struggling and grasping for any positive news to rally.
While one month of data is never enough to draw any concrete conclusions, a market bounce was long overdue. Unfortunately, the bounce was short-lived as CPI unexpectedly rose in August, which led the Dow and S&P 500 to their worst days of the year!
Excluding food and energy, CPI rose by 0.6%, which was higher than expected and led the Federal Reserve to raise interest rates by three-quarters of a percent for the third straight time. They also indicated that they will continue raising rates until the funds level hits a “terminal rate,” or endpoint, of 4.6% in 2023.
This implies a quarter-point rate hike next year but no decreases. Of course, like everything else, this is subject to change.
What does this all mean? It likely means more volatility ahead for all asset classes. Unless the Fed backtracks or inflation drastically declines, investors should brace themselves for more bumps in the road ahead. Several factors are playing into this, and while never enjoyable, it is important to note that markets tend to rally when things seem bleak.
Risk-Free Return
For much of the past decade, the phrase “there is no alternative,” also known as “TINA,” was king. With interest rates near record lows, equities and certain bonds were the only game in town. Much of this was a coordinated effort by central banks to help boost values through asset price inflation. This plan worked until stubbornly high inflation derailed it.
As of this writing, you can obtain the following “risk-free” rates of return:
Online savings yielding ~2.15%
One-year CDs yielding as high as ~4%
Two-year U.S. Treasury yielding ~4%
While the real yields remain negative when factoring in inflation, these are some of the highest rates we have seen since 2008! The craziest part is nearly all of this increase has occurred in the past seven months!
The chart above shows how quickly rates have spiked on the two- and 10-year Treasury. With more rate hikes on the horizon, we could see them increase even further. This marks the first time since 2008, minus a brief uptick in the fourth quarter of 2018, where Treasury yields are attractive enough to make investors stop and think about putting their cash to work in risky assets, mainly equities.
While we know equities outperform treasuries over the long run, who is to say they will over the next several quarters? While no one can accurately answer that, earning 4% is enough for some to keep/allocate a portion of their portfolio in risk-free assets. Unless you are confident that you will earn significantly more, it could take a while for people to rush back into equity markets.
Consumer Price Index Components
There have been some positive developments on the inflation front. While CPI remains higher than desired, looking underneath the surface reveals some positives.
Many proponents of the Fed want them to slow the pace of interest rate hikes as American households are in better financial shape, as asset price inflation and wage inflation have helped soften the blow. They argue that aggressively raising rates could “force” us into a recession. The tricky part is that the impact of rate hikes isn’t felt for several months, making it harder to gauge the effectiveness in the short run.
While energy, used cars, new vehicles, and apparel are well off their 12-month inflationary peaks, components such as food, transportation services, shelter, and medical care services remain at or near their peak.
The Fed wants to see inflation drop across the board before signaling a pause on rate hikes. This is risky as too many rate hikes could push us into a recession. At the same time, too few rate hikes could have the same outcome because inflation can be elevated for only so long before it tips the economy into a recession.
While supply chains have slightly improved, they have not reached pre-pandemic levels, partially contributing to the price elevation as demand continues to outstrip supply. With higher rates, the economy is likely to slow, which indirectly should help supply chains since demand will likely cool over the coming quarters.
It’s important to remember that the global response to the pandemic was an experiment of sorts and hindsight is 20/20. The Federal Reserve has admitted their mistakes in waiting far too long to start raising rates and assuming that inflation was transitory. They are left playing catch-up, and the question is: Are they too late?
Valuations
While things feel very uncertain, equity and bond markets have been trading at their cheapest valuations since early 2020. Of course, it doesn’t mean that things can’t get worse, but a lot of damage has already been inflicted. Investors should be looking at this time as a good long-term buying opportunity.
One metric commonly utilized is the Shiller P/E Ratio. It is a valuation measure applied to the S&P 500. It is defined as the price divided by the average of 10 years of earnings (moving average), adjusted for inflation. It is a good tool to help assess future returns over longer periods.
As seen on the chart, the P/E ratio has dropped significantly this year. And while the S&P 500 is not “cheap” by historical measures, it is not frothy like it was to start the year. The question is what the coming quarters will look like, given that interest rate increases tend to take a few months to show up in the economy.
Since July, the Shiller P/E has dropped further, putting it at a multiyear low. While uncertainties remain, certain equity and bond markets are presently “cheap” by historical valuation measures.
After monumental returns over the past three years, a decline was to be expected. Of course, many were not expecting both equities and bonds to drop this much. But few expected them to rise as much as they did the years prior.
A prolonged period of negative returns like we’ve experienced this year will likely test your patience—that is to be expected. It’s hard to wait for the recovery, but it’s coming; we just don’t know exactly when.
Hang in there …
Discuss your situation with a fee-only financial advisor.