The 19% rally off the mid-June lows for the S&P 500 stock index ended in mid-August. From that point and through September was a tidal wave of selling resulting in another down quarter and the lowest levels for the major stock indices since the second half of 2020.  The last three weeks of September were just awful, prompted by a high August inflation number, strong employment and the negative reaction to the new British Prime Minister’s and her finance chief’s (called the “Chancellor of the Exchequer”) tax plan.  The inflation and employment data prompted the Federal Reserve to hike rates by another 0.75%, their third such hike in as many meetings.  Higher interest rates are meant to increase the cost of borrowing and capital so that consumers and businesses alike slow their spending and investment.  This cooling of demand is intended to slow economic activity and price increases.  Aside from likely reducing companies’ earnings, it also reduces the multiple that investors are willing to pay for a stream of earnings, creating a double whammy for stock prices. 

Predictably there are problems for the markets when the Federal Funds Rate increases rates and there is global instability.  One big problem is that money is attracted to the US Dollar.  Much of it is to take advantage of the higher returns on U.S. Treasury securities and because the dollar has been the world’s “reserve currency” for decades.  This reserve currency status means commodities and goods traded in global markets are priced in dollars so countries with weak currencies are now paying much more for energy and other goods, likely leading to recessions.  Another problem is that economic activity slows as mentioned above.  We have already seen signs of that in the housing market as higher mortgage rates have slowed housing starts and sale activity.  There is always a lag between the hike in interest rates and the intended effect of slowing the economy.  The Federal Reserve should certainly be aware of this and may stop increasing or reverse course to avoid putting the economy into a steeper than intended decline.  I believe the end of the interest rate increases may be coming sooner than may are predicting and Fed board members are indicating.  Otherwise, pundits will cite the Fed as being late to address the inflation issue thinking it was “transitory” and too late in restarting the economy by halting their rate increases.   

While all this sounds terrible, and it is hard to argue that it isn’t, there are countervailing economic effects as the measures undertaken take hold.  One is the negative wealth effect of the declining markets which has an impact on consumer psychology and will reduce demand, thereby helping to reign in price increases.  Also, the slowing economy will have an impact on job supply and multiple Federal Reserve Board members have already forecast a rise in unemployment for the remainder of this year and next.  There has recently been a reduction in the job openings as shown in the latest JOLTs report (Job Opening and Labor Turnover) which led to a modest rally the first two days of October.  The two mandates of the Federal Reserve are to get inflation moving towards their target rate, which now stands at 2%, and to maintain full employment.  As inflation rates decline and unemployment goes up, it gives the Fed the latitude to lower rates to what they view as a more normal, long-term level.  Lower interest rates make investment by both businesses and stock market participants more attractive.

Bond markets continued their slide during the third quarter and have had a historically bad year as increasing rates and the prospect of continued Federal Funds Rate increases led to higher yields and lower prices, as bond prices move inversely to yields. The AGG ETF, which holds investment grade government, agency and corporate debt was down over 13% for the year through September 30^th.  The selloff has led to yields on investment grade corporate bonds and U.S. Treasuries that are now more attractive than I’ve seen in years. I have put cash that had been idle in fixed income allocations to work during the quarter.

I hope you are all well had a great summer. Should you have any questions about the attached report, this email, your portfolio, or anything else related to your financial life, my line is always open.

Best regards,

Steve