The US economy is still running hot. The third quarter brought more of the same volatility seen throughout the year. The markets are adapting to The Fed’s medicine: higher interest rates to slow the economy. On September 21st, The Federal Reserve bank increased the federal funds rate by another 75bps. This was widely anticipated. However, in his comments, Fed Chairman Powell emphasized that their number one focus is fighting inflation. Until this point, markets had been reluctant to take him at his word with many expecting that he might soon pause or reverse. Now, the message is clear, the Fed will do “whatever it takes” to beat inflation.
Along with their policy rate, the Fed updated their economic projections, which outlined another 1.25% to 1.5% of rate hikes this year which implies another 75bps hike in November and at least 50bps in December which would have rates peaking north of 4.5% in 2023. As the stock market reacted with a quick and violent downturn, Minneapolis Fed President Neel Kashkari commented, “People now understand the seriousness of our commitment to getting inflation back down to 2%.[1]” And this seems to be the case globally as major central banks made tightening moves in other parts of the world. All are determined to wring inflation out of the system, even if doing so is painful to consumers or stockholders. The Fed’s task at hand is not just to stabilize the inflation rate but force it down to the target rate of 2%. No small feat. History says that, with inflation this high, you need to fight it sooner rather than later, and you cannot pause until the job is done.
Market Impact
The market’s negative reaction is logical. With higher interest rates, the cost of capital for companies increases and investors begin to view profits generated by companies today as more attractive than profits in the distant future. Over that past 40 years, interest rates have mostly fallen. However, after the Financial Crisis, the Fed reduced rates to historic lows (almost zero[2]) to bolster the economy by easing lending and making capital more readily available. With interest rates near zero, and capital readily available, high growth companies brushed past any inquiries about profitability by urging investors to focus on the possibility of tremendous profits in the nebulous future. Now that Zero Interest Rate Policy is finally reversing, profitability today is the only game of interest. Full stop.
Delivering $100 to an investor in ten years is not the same as delivering $100 to an investor today. If you have $100 to invest, you can earn interest on your cash. As rates hovered near zero (0.25%) during the heart of the pandemic, an investor would be indifferent to $97.53 today or $100 delivered in 10 years. (An investor could take $97.53, invest it at 0.25% per year, and they would have $100 in ten years.) As interest rates increase to a target of 4.5%, that $100 promised in 10 years is suddenly worth only $64.39 today, a 34% decline in value. Thus, unprofitable growth stocks (and company values in general) are worth much less today than they were in a Zero Interest Rate Policy environment. And even more so for companies requiring debt to fund their business as the costs of borrowing money have increased significantly.
The impact on the housing market is similarly acute. The National Association of Realtors expects home sales in the US to fall 9% this year with price growth expected to cool to 5% in 2022 after double digit gains in recent years. A recent Bloomberg note highlighted the impact on home buyers. In 2021, with a 20% down payment and a $2,500 month mortgage, a homeowner could afford a $759K home. At today’s mortgage rates, that same 20% down payment and $2,500 monthly mortgage payment would only get you a $476k home[3]. A 37% decline in buying power.
These sharp changes in interest rates drastically change firms’, and investor’s, thinking. Cash today is more valuable than in the future. The return on investment expected for each new investment is much higher when investors have the option to put their cash to work in a “risk-free” asset (debt obligations issued by the U.S. Department of the Treasury backed by the full faith and credit of the U.S. government) for reasonable near term profits. For companies and investors, lower interest rates were a helping hand for the market that is now being withdrawn.
Interest rates affect the economy by influencing, stocks, bonds, consumer spending, and inflation. As we enter this new environment, it’s important to remember there is a lag. It generally takes 12 months for the economy to feel the effects of interest rate changes. We aren’t yet seeing the impact of their drastic moves, and this shouldn’t be overlooked. With hopeful expectations of a “soft landing”, a good analogy would be to consider a pilot attempting to land an airplane when, after turning the yoke or pressing the rudder peddle, it took 15 minutes for the plane to react. Under that scenario, it would be unreasonable to expect a soft landing. To the contrary, turbulence and a rough grounding would be more than likely. For the Fed, we can expect that they will inevitably over tighten and then have to drastically ease to overcorrect in the other direction. The result will mean more volatility.
While this near-term reality is painful, it’s important to keep in mind that we are more than likely closer to the end (a bottom to the market) than we are to the beginning; especially if we see signs of inflation moderating. Since World War II, the average bear market has lasted roughly 11 months and, from the valley, the ensuing bull market lasts nearly 5 years with an average gain of 130%[4]. Markets are forward looking, and the market will emerge from this bear market before the recession has ended.
[1] https://www.reuters.com/markets/europe/feds-kashkari-happy-with-market-reaction-powell-speech-bloomberg-2022-08-29/
[2] Often referred to as Zero Interest Rate Policy.
[3] Example implies 2.82% and 6.87% annual interest rates respectively.
[4] Source: Bloomberg Data
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