Fed Policy and the Impact to Markets
Last week, the Federal Reserve announced that they would be maintaining the target Fed Funds rate (5.25% - 5.50%, the highest rate in 22 years) in September, but it still expects one more hike before the end of the year. This was expected. However, there was a slight plot twist in the Dot Plot (a chart showing where the Fed members think rates should be), which shows the projected interest rates at year-end through 2026. The Fed’s median projected Fed Funds rate at the end of 2024 increased from 4.6% in the June Dot Plot to 5.1% last week. The 2025 median projection rose from 3.4% to 3.9%. While interest rate cuts are still projected in the coming years, the key takeaway is the Fed thinks rates will be higher than previously forecasted for a longer period of time. These projection changes from the Fed caused increased volatility and downside pressure to both stock and bond markets.
As a reminder, rising interest rates worry equity investors for two primary reasons:
Higher interest rates equal higher borrowing costs for companies and consumers. Higher corporate borrowing costs may hurt profit margins and increase costs for new projects or other expansion plans. Higher consumer borrowing costs, such as mortgage rates, auto loans, etc. may reduce consumer spending. Therefore, higher borrowing costs impacts economic growth and possibly corporate earnings.
The second reason why higher interest rates worry equity investors involves investment fundamentals around valuation. When an investor values a company, one common way is to look at future cash flows or earnings and attempt to determine what they are worth today. Because this valuation methodology relies on current interest rates to determine the present value of these future cash flows/earnings, higher interest rates or bond yields reduce stock valuations. Technology stocks usually struggle in a rising rate environment (2022) because rapid growth assumptions are usually built into their valuations. This explains why the technology sector was the worst performing sector last year and last week after the projected interest rate changes.
We believe that the recent volatility surrounding these projected interest rate changes is a little silly misguided for 3 reasons.
Economic data over the past month such as retail sales, industrial production, 2nd quarter GDP, and early 3rd quarter GDP indications, all suggest the U.S. economy is pretty resilient in spite of the rapidly rising interest rates over the last 18 months. Part of the reason that the Fed projects higher rates for longer is that they expect faster economic growth and lower unemployment this year and next year than they had foreseen just three months ago. Shouldn’t that be good news?
Inflation has been trending in the right direction, even though it has been stickier than we’d prefer. In August, core CPI, a measure of inflation that excludes volatile categories food and energy, eased to a 23-month low of 4.3% year-over-year. This is well off the high of 6.6% last September. Headline CPI (which includes food and energy) was impacted by rising energy prices and ticked up to 3.7% vs. 3.2% the month before. This is still well off the high of 8.9% in June 2022.
Most importantly – We don’t believe it’s wise to make portfolio changes based on Fed projections, because they’ve been really bad at projections historically. The Fed told us all through 2021 that post-Covid inflation would be “transitory”. This was obviously wrong and caused them to be late to the party of trying to get inflation under control. At their September 2021 meeting they forecasted Core CPI to end 2022 at 2.3%. It was double that at 4.6%. At their September 2022 meeting, they forecasted real GDP to end 2023 at 1.2%. It is currently tracking at more than double that at 2.5%. Economic forecasting is difficult. Why should we put much confidence in their current forecasts for 2024, 2025 and 2026?
Bottom Line: There could be more volatility ahead as the markets sort through these concerns. We would encourage patience and to remember that inflation has been trending in the right direction, the US economy has been resilient despite rising interest rates, and it’s not prudent to make big portfolio changes based on projections of future interest rates or other economic forecasts.
As always, if you would like to discuss your portfolio or financial plan, please don’t hesitate to reach out. Thank you for the continued opportunity to serve you.