Through a home-school co-op, I teach an economics class to juniors and seniors. I usually take time for what I call the “Real World Minute” where we apply what we are learning to what is currently happening in the economy. As you can imagine, inflation along with the Federal Government’s (fiscal) response and the Federal Reserve’s (monetary) response has been at the forefront. They can all relate, just as you, to the higher prices we are paying. What surprises me are the discussions initiated by them as they realize the inadequate, ill-timed, and/or non-coordinated fiscal and monetary responses that have exacerbated this inflation cycle. Now, if only our politicians and financial leaders could recognize what these high school students have.
The Fed continues to unwind its “great experiment” as I mentioned in my last newsletter. The rapid rise in interest rates, has been met with some unintended consequences. As we discovered, some financial institutions, while not holding low credit quality instruments, were caught holding long-term quality fixed income which, with the meteoric rise in interest rates, lost value. This created a mismatch between assets and liabilities for some of the smaller regional banks. This is not like the financial crisis of 2008-2009, and it appears as if the acute phase of this situation has passed. What we do expect is some amount of credit tightening, and expectations of additional regulation over the banking industry. Both are potential headwinds for banks in terms of reduced earnings and slowing economic growth. This may not be all bad as this helps set up what should be the last rounds of Fed tightening over the next couple of months.
Starting this quarter, we will begin to see the impact of the Fed’s actions in year-over-year comparisons of corporate earnings and profitability. In addition, while we expect slowing growth in the economy, it is still growing at a decelerating rate. The question remains whether we will experience a Fed-induced recession or a soft landing. Currently, we give a mild recession about a 40% chance of occurring.
One of the biggest silver linings to come from this bear market cycle is the increase in income in the portfolios. We have worked to take advantage of the tremendous jump in interest rates, and we are seeing the fruit of this in the accounts. Especially for those of you who are taking cash flow from your portfolio for living expenses, everything else being equal, this increase in cash flow means we are less dependent on the stock market going higher to meet those cash flow needs. This is a definite positive.
Considering the future, as I mentioned, we expect the Fed’s action on interest rates to come to fruition throughout the year. A wild card is the tight labor market and its sticky impact on inflation. Unfortunately, the Fed wants to see unemployment rise to combat this situation. In addition, there remains the potential for headwinds over the next 2-4 months culminating with the debt ceiling showdown in Congress. The potential for volatility remains high, however we believe it will not be long- lived if it does occur, and may present another reallocation opportunity. In our portfolios, we continue to focus on quality equities, and a fixed-income market that is shifting away from a rapidly rising interest rate environment. Remember, historically the stock market will come out of a bear market 6 to 9 months prior to the economy bottoming. It appears we are well on our way to this point in this cycle.
As always, thank you for your trust. Please let your advisor know if you would like to discuss anything in more detail.