Dorato News - October 2022
Portfolio Issues - Optimistic
The negative stories about the economy and about the world continue under a steady drumbeat. The Federal Reserve is raising rates to fight inflation; global recession is imminent; stocks and bonds fall; war in Ukraine; natural disasters everywhere. It’s enough to cause a sleepless night for even the hardiest snoozer.
And yet, we’re optimistic. You might think we’ve lost our marbles, but we don’t think we have. The Federal Reserve is raising rates to fight inflation, as it should. In the 1970s, policymakers thought they could allow some inflation to keep unemployment low. That didn’t work out because people aren’t stupid. They raised their inflation expectations accordingly. It took sky-high interest rates and a nasty recession to convince people otherwise. The current adjustment will be much less painful.
Stocks and bonds are both down this year, so no diversification benefit. But going forward the expected returns on both stocks and bonds has improved because we’re starting from lower prices. If policymakers were making the wrong policy choices we wouldn’t be so sanguine. Witness Turkey, for example, where the central bank is lowering interest rates in the face of galloping inflation. Bad idea. But the Federal Reserve will accomplish its goal soon, and the mood will switch.
Through the last 100 years, the US stock market has provided an average annual return of about 10%. That's through all kinds of booms and busts. We think the policy is in place to keep that on track. Prices are not cheap, but they’re reasonable, and that’s the source of our optimism.
“911? I’m calling about my husband. He says he’s optimistic.”
Market View - Painful Progress
Inflation is being stubborn. Central banks around the world are raising rates in unison to try to stamp it out, but it has proven to be as resilient as a cockroach. However, signs of progress are emerging. Rents dropped on a monthly basis for the first time in two years, the housing market is cooling off and the US treasury ten year yield is climbing towards 4%. These indicators show that interest rate hikes are starting to take effect, which will save us from larger problems down the road. It is useful to remember that any time the Fed raises or lowers rates, it takes time to work it’s way through the economy.
Rate hikes have wreaked havoc in both the stock and bond markets. All of the major US stock indices are officially in bear market territory (down 20% from a recent high), while the aggregate bond index is down approximately 14%. That is tough to digest for most investors, but especially for bond investors that have grown accustomed to price stability over the last 40 years. You have to look back to the 1980’s to find a time when bonds had a similar loss in value. That’s why the bond market has investors feeling especially queasy this year.
As rate hikes move forward at an aggressive pace, the US Dollar has appreciated in value. Investors often turn to the dollar in times of trouble; this trend has been exaggerated by the large increase in rates that makes investment in the US more enticing for foreign investors. Add those higher rates to the troubles faced in some of the world’s larger economies and you can see why the dollar has been particularly strong this year.
The government in Britain announced a tax cut despite simultaneously announcing a large energy subsidy. That announcement was met with strong criticism and they quickly canceled their plan. They want to help their citizens with outrageous prices for natural gas this coming winter due to the conflict in Ukraine. That is admirable, but their hope that a tax cut could help jumpstart growth in a stagnating economy when they are already contending with high inflation and a weakening currency seems far-fetched. This comes at a time when they are still navigating through the turmoil of leaving the EU, their largest trade partner. All of that to say, the future looks precarious for the UK economy.
The dollar’s strength is another area of pressure for US multinational companies. Their profits in other countries take a hit when the dollar appreciates because when they convert those foreign profits, they can buy fewer dollars. So, while the dollar strength is good for those of us traveling abroad, it can ultimately lead to lower earnings for companies, which can be another drag on stock prices. Most of these companies practice currency management for scenarios such as these, so we don’t think this will have an outsize effect on earnings.
Gasoline prices have fallen 26% from their high in June and oil prices are at their lowest levels since January. That drop is a welcome relief for consumers and is good news for any businesses that are energy or transport intensive. It also helps inflation measures, as energy is one of the key components of the Consumer Price Index.
Looking ahead, we think it is likely that we will have similar headlines throughout the rest of the year. Unless some other big story emerges, investors will continue to monitor the Fed’s every word and attentively survey economic data for more signs of taming inflation. Once inflation looks under control though, expect a new set of stories to work their way into the headlines. As inflation moves to the background, companies are likely to present better earnings and more optimistic views on the future. That will be good news for investors, who will be happy to put this year behind them.
Sources: Economist, Wall Street Journal, Value Line, Vanguard, Applied Finance Group, Schwab