By Matthew McKee, CFA, CFP® and Adrian Colarusso, CFA, CFP®
April 16, 2023
In our last newsletter, we highlighted that markets haven’t rewarded conservative positioning so far this year. Risky growth assets recorded a stellar Q1 despite three bank failures and rising economic uncertainty.
The Fed’s dual mandate is to maintain full employment and a 2% inflation target. But markets have come to see a third mandate – promoting market stability – the so-called “Fed Put”.
It is a reprise of the old post-Financial Crisis playbook: “bad news is good news.” With increasing risk and uncertainty, market participants believe the Fed will step in and cut rates to support continued growth. Investors counting on the Fed to bail them out if their assets drop in value might be in for a rude awakening.
Since March 8, expectations for the Fed funds rate have decreased significantly, which has in turn pushed growth assets higher.
We believe this muscle memory from a bygone era may lead investors astray.
Source: BlackRock. Implied path of Fed Funds rate based on interest rate futures.
There is no higher priority for the Fed right now than inflation, which remains stubbornly high.
This is why we are focused on companies that have stable earnings and low leverage, which we believe will best weather a sustained period of higher interest rates and inflation.
Why we remain (slightly) defensive
Although the first quarter has smashed our expectations for weak stock performance, we believe short-term risks in the markets remain asymmetric to the downside. However, long-term investors should not take this as advice to sell their stocks or keep too much cash on the sidelines.
What we heard on the recent JPMorgan earnings call reflects our views.
CEO Jamie Dimon noted that “…the storm clouds that we have been monitoring for the past year remain on the horizon, and the banking industry turmoil adds to these risks.” He also added that banks could rein in lending, which may prove to be both a cause and effect of the impending economic slowdown.
Fed notes from the March meeting highlight their base case of a mild recession later this year. The market took it in stride, assuming the Fed will begin to cut rates soon, despite Fed officials’ repeated and adamant messaging that rate cuts are far from imminent. We prefer to listen to the Fed.
It is much more important for the Fed to get inflation under control than to support stock prices. Before Covid (and inflation), it was reasonable to assume that the Fed always had a rabbit to pull out of its hat to support asset prices. This caused many investors to take risks that today are not as prudent.
The good news is that headline CPI numbers released on Wednesday showed some signs of inflation easing. But the core rate, which excludes more volatile food and energy, ticked up 0.4% to 5.6%.
We will keep a close eye on the PCE numbers, the Fed’s preferred inflation gauge, next released on April 28th.
Banks also began reporting this week with JPMorgan and Wells Fargo showing better-than-expected earnings as net interest margins improved. There were also deposit inflows which appear to be a “flight to safety” from the smaller regional banks. Market participants will certainly scrutinize these regional banks this earnings season more closely than in prior quarters. Lending standards are tightening, and the most important question is what impact that will have on growth over the next several quarters.
What if we’re wrong?
This may turn out to be the most telegraphed recession that never happened. To be clear: our cautious positioning is far from a “bet the farm” proposition in our client portfolios.
Our allocations are calibrated taking this possibility into account. We would rather underperform slightly in a puzzling up-market than chase that rally and underperform on the way down.
While we remain skeptical of the mythical soft landing (see 2023 outlook) the possibility remains. Despite our modestly defensive positioning, we would still be happy to see continued growth in the markets for our clients for the rest of the year.
Our role as wealth advisors
The most important work we do for clients is to help them match their goals and risk tolerance to the right kind of investment portfolio.
Our investment process strikes a balance that responds to changing market dynamics while sticking to a sound, long-term strategy that includes multiple asset classes in carefully measured proportions.
Last, but certainly not least, we provide holistic wealth planning advice that draws on our broad knowledge of opportunities to save on taxes and align a family’s full set of resources to their goals.