Fed: With so much riding on the Fed’s moves, it’s hard to know how to invest

Making money was easy for investors when they could credibly believe that the Federal Reserve could pull out of its aggressive inflation-control campaign at any cost. But harsh words from Fed Chair Jerome Powell, bolstered by a series of large rate hikes, eventually convinced markets the central bank meant business, sending stocks and bonds down.

Nervous confidence returned in early October as stocks staged a major two-day rally, but then prices fell again. Investors initially seemed more confident that the Fed would change course, but concerns returned as they worried about how much damage would be done before it did so. Where markets go from here and how one positions an investment portfolio depends on whether and how cleverly the Fed changes strategy.

“There’s a crescendo of factors coming together that leads me to believe we’re going to have a few more weeks of pain before the Fed capitulates,” said Marko Papic, chief strategist at Clocktower Group.

Papic believes a dovish turn could be coming soon as the Fed signals it would settle for inflation 2 or 3 percentage points above its 2% target.

Others think there’s more pain ahead, maybe a lot more. A prerequisite for a pivot could be a “credit event,” said Komal Sri-Kumar, president of Sri-Kumar Global Strategies, which means a default by a large investment firm or a corporate or government borrower, often with severe consequences.

The Fed’s plan is to curb inflation by slowing economic growth, and part of their plan is working. The Conference Board reported last month that its index of 10 forward-looking indicators fell for the sixth straight month. The Purchasing Managers’ Index, a gauge of the manufacturing sector, has risen in just two of the last 10 months. However, inflation remains stubbornly high, with consumer prices up 8.2% for the year to September, all but ensuring the Fed will hike rates further.

The growing realization that the Fed is likely to remain hawkish has sent the S&P 500 into the crash. It lost 5.3% in the third quarter after rising nearly 14% midway through the period. The downturn began to accelerate in late August when Powell addressed the annual economic conclave in Jackson Hole, Wyoming. He mentioned inflation 45 times, and on the Fed’s program to bring it back to 2%, he said: “We’re going to hold on until we’re satisfied the job is done.”

His outspoken language also helped drive down bond prices, which are inversely correlated to bond yields. The 10-year Treasury yield rose from 2.6% in early August to 4% at the end of September, giving credence to forecasts that the Fed would tighten further until its benchmark rate reaches 5%.

High interest rates are not the only cause for market concern. The dollar recently hit a 20-year high against other major currencies. Although a strong dollar mitigates inflation of imported goods in the United States, it makes American goods and services more expensive in world markets, exacerbating inflation abroad and hurting many American companies, increasing the likelihood of a recession in the United States.

Add to that Russia’s war in Ukraine, which casts doubt on Western Europe’s ability to meet its energy needs this winter. Threats from Russia’s leaders to use nuclear weapons could hit stocks hard.

If the Fed eases its stance, markets could recover. But Mohamed A. El-Erian, chief economic adviser to the alliance, warned that it could do more harm than good.

“Now that the Fed is in such an awkward situation – one that it has largely created itself – it may be inclined to avoid further rate hikes,” he wrote in a comment for Project Syndicate. “However, such an approach would risk repeating the policy mistake of the 1970s and leaving America and the world with an even longer period of stagflationary tendencies.”

(Stagflation — high and persistent inflation combined with sluggish growth — is the worst of both worlds economically.)

The Fed can be damned if it turns and damned if it doesn’t. In a recent CNBC interview, University of Pennsylvania finance professor emeritus Jeremy Siegel accused the central bank of ignoring worrying signs for the economy, including weak housing indicators and a collapse in monetary growth.

During and well after the 2008 global financial crisis, the Fed kept interest rates low and bought billions of dollars worth of securities — actions that pushed up asset prices and supported the economy. Now the Fed has pushed down the value of stocks and bonds by raising interest rates and reducing its holdings.

“Asset prices have become a lever used by the Fed to ease price pressures,” Michael Farr, CEO of financial advisory firm Farr, Miller & Washington, wrote in a note to investors. “The strategy, which appears to be fraught with danger, is designed to induce a reverse prosperity effect by lowering asset prices, making people feel less wealthy and therefore spending less. Lower spending means less demand, which means lower inflation. At least that’s the hope.”

It’s a hope Farr holds onto. He noted that inflation expectations indicators show that investors “continue to believe that the Fed will be successful in cutting inflation over the medium term.” If so, it would help markets recover even if there is no dovish reversal.

Tony DeSpirito, BlackRock’s chief investment officer for US fundamental equities, is also bullish.

“In the short term, I can see inflation rolling over,” he said. “Some companies are reporting excess inventory, home price growth has turned a bit negative. The real question is how fast it will fall and to what level.”

He expects CPI to settle around 3-4%. But inflation is likely to remain a chronic problem, he says, as certain trends that have kept it in check for decades, notably trade liberalization, ease and the focus shifts from supply chain efficiency to resilience.

“The long-term disinflationary impulse has ended,” DeSpirito said.

As for near-term inflation, if the Fed is trying to contain it by actively targeting asset prices, it has at least achieved part of the targeting. According to Morningstar, the average domestic equity fund fell 4.2% in the third quarter, with technology, communications and real estate portfolios underperforming.

The average international equity fund lost 9.5%, with Europe and China funds performing particularly poorly.

Bond funds offered no sanctuary, with the average portfolio down 2.7%.

Positioning an investment portfolio is particularly difficult these days, given the uncertainty surrounding what the Fed will do next.

Sri-Kumar advises caution on equities and risky corporate bonds and recommends government bonds and other high-quality bonds. The 10-year yield won’t be higher than 4%, he predicted.

“Stay underweight equities and start getting your toes wet in long-dated, highly rated debt,” he said.

With so much uncertainty, DeSpirito prefers a barbell approach to stocks. Own some in industries that do well when economic growth picks up, like energy and financial services, and others in industries that hold up in a recession, particularly healthcare, he said.

Clocktower Group’s Papic expects a quick turnaround and favors energy and industrial metals commodities.

He advises buying bonds “if you’re in the camp that thinks the Fed is going to break something.”

He doesn’t think the Fed will break anything, but that it might come close.

“The next few months are really scary,” Papic said, “but the Fed will address a number of factors in November – CPI falling, US geopolitical allies suffering, US economy being negatively impacted – that will be taken together , to tell them that the current pace of hawkishness is not necessary.”

This article originally appeared in The New York Times.

https://economictimes.indiatimes.com/markets/stocks/news/with-so-much-riding-on-the-feds-moves-its-hard-to-know-how-to-invest/articleshow/94890733.cms Fed: With so much riding on the Fed’s moves, it’s hard to know how to invest

Russell Falcon

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