by Andrew Vanderhorst, CFA, CAIA, CFP®, Chief Investment Officer
We witnessed a resurgence in market volatility during the first quarter as clouds of uncertainty hindered near-term visibility. The S&P 500 climbed almost 10% early in the quarter on expectations that inflation would continue to moderate and thus, the Federal Reserve (the Fed) would not need to raise interest rates much further. Those hopes were soon dashed as stronger than expected jobs growth and sticky core inflation (i.e., excluding food and energy prices) suggested that the Fed would have to continue raising interest rates well-beyond initial expectations. Then, the banking sector experienced a crisis of confidence as three US banks failed in quick succession, suggesting the Fed had overtightened monetary policy. Despite the market’s concerns, the S&P 500 still finished the quarter in positive territory.
The rapid increase in interest rates over the past year combined with poor risk-management at these banks were the main culprits for their failures. While the issue appears to be isolated amongst a few such undiversified banks, the impact was felt across the entire financial sector. The result was greater uncertainty about the direction of interest rates from here: will the Fed lower interest rates to contain the near-term financial sector woes or will they continue to focus on the longer-term issue of reducing inflation?
Understandably, the market remains concerned that the Fed will overtighten financial conditions and increase the risk that the US will enter a recession. Such an outcome will inevitably draw questions about whether the cure (higher interest rates) will be worse than the disease (higher inflation). Although the near-term effects of tighter financial conditions may be painful, they are typically much preferred to the alternative of stubbornly high inflation. One must simply recall the ultimate effects of the Fed not choosing to sufficiently tackle inflation in the 1960s and 1970s to understand that the cure today is more appealing than the more aggressive treatment that would be required years from now.
Recent economic reports suggest that the Fed can continue to raise rates to dampen inflation. Indeed, the Fed meeting in March resulted in another 0.25% increase to the Federal Funds rate. The Fed’s newly updated dot plot also suggests that the Fed still sees sufficient evidence to continue raising interest rates for the next few meetings. The median expectation from the voting members of the Fed is that they are close to reaching peak interest rates, but they do
not foresee cutting interest rates until 2024 at the earliest. Instead, future Fed decisions are expected to be very much data dependent.
Investors, however, believe that the Fed will have to start cutting interest rates soon. The yields on short-term US Treasuries climbed early in the quarter only to reverse course. The 2-year Treasury note yield climbed to over 5%, but ended the quarter below 4% indicating that the bond market expects the Fed to start cutting rates this year. Currently, the futures market expects the Fed to cut interest rates by 1% over the next 12 months.
In the near-term, we expect both the stock and bond markets to continue to display high levels of volatility. All eyes will be monitoring monthly economic reports, especially non-farm payrolls, unemployment, and inflation, to gauge the Fed’s likely decision at their next meeting in May and the path of interest rates through year-end. Meanwhile, the first quarter earnings reports from US companies will be closely scrutinized for any signs of slowing sales growth and net profits. Such signs would be in-line with already tightening financial conditions and may weigh on stock prices. Despite the near-term uncertainty, we believe a diversified portfolio of high-quality dividend and growth companies combined with prudent amounts of short-term bonds and cash will help our clients ride out the storm and continue to meet their financial goals.
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