Key Points:

• The Federal Reserve is expected to raise the Fed Funds rate an additional 75 basis points in November to contain high prices.
• Stocks rallied strong in October with the Dow having its highest monthly return in decades.
• Higher yields in bonds have caused bond prices to fall but investors are finally getting attractive yields in short-term assets.

The Federal Reserve is primed to raise its benchmark rate another 75 basis points this week in their conquest to slow down economic activity and bring down inflation.  This will be the fourth consecutive increase of that size as inflation remains stubbornly high.  Despite higher rates, the US economy advanced 2.6% in the third quarter after two quarters of economic detraction.  The main components driving growth were increases in exports (mostly energy) and consumer spending.  Higher interest rates are being felt in the housing market as sales of new homes fell 10.9% in September as surging mortgage rates are giving would-be buyers pause.  US mortgage rates topped 7% for the first time since 2002 and will likely cause prices of existing homes to fall.  This drop in prices will take time to show up in inflation calculations making the Fed’s job more challenging.

Stocks rallied in October on the hopes that the Fed may be closer to slowing rate increases.  The Dow Jones Industrial Average posted its best month in decades, gaining 14.07%. The more diversified S&P 500 advanced 8.1% while the tech-heavy NASDAQ gained just 3.94%.  Value stocks were the best performers during the month with strong gains in energy (+24.96%), industrials (+13.92%) and financials (+11.99%).  Earnings (which ultimately drive stock prices) have come in rather strong this quarter.  Through the end of October nearly 71% of the 263 companies that have released third quarter results have beaten their expectations according to Guggenheim Investments.  Small cap stocks had a solid month with the Russell 2000 gaining 11.01%.  International stocks were mostly flat for October as high inflation in Europe and a selloff in Chinese equities had global investors seeking solace in US dollar assets.

Higher interest rates continue to weigh on the bond market with the Bloomberg Aggregate bond index falling 1.3% in October.  Two-year Treasury yields topped 4.6% during the month after yielding below 0.5% just a year ago.  While this has been one of the most challenging environments to be a bond investor, it has been years since yields have looked this attractive.  Strong corporate balance sheets should provide stability to high quality bond investors if we experience a recession over the next year. High yield bonds held up well during the month (+2.68%) but it may be a bit early in the economic cycle to take on excessive risk in the bond market. In the meantime, investors are finally earning something on short-term bond investments.

Sources: Morningstar Direct, JPMorgan, First Trust, Wall Street Journal

Key Points:

• The Fed’s aggressive stance to combat inflation is causing pain in the stock and bond markets as higher rates pushed risk asset prices down.
• Stocks and bonds experienced their worst month of the year with the probability of a recession increasing as the Fed continues to pull liquidity from the system.
• Current yields and valuation levels in stocks and bonds look much more attractive than we have seen in the past few years.

After mischaracterizing inflation as “transitory” last year, the Federal Reserve has been playing catchup in an effort to reign in rising prices this year.  The extremely aggressive rate hikes by the Fed to slow down economic activity and ultimately prices has caused pain in the financial markets.  Tighter financial conditions increase the probability and depth of a recession.  The Fed raised the Fed Funds rate an additional 75bps (0.75%) in September, after raising it 75bps in both June and July meetings. Chairman Powell vowed to “keep at it until the job is done”, suggesting more rate hikes this year.  Higher rates from the Fed make their way into the rest of the economy in the form of higher mortgage rates, auto loans and overall borrowing.  Eventually the prices of goods will come down but the latest CPI reading of 8.3% in August for the year-over year increase in prices is a far cry from the Fed’s 2% target.

Stocks and bonds experienced their worst month of the year with the S&P500 dropping 9.21% while the Bloomberg US Aggregate Bond Index fell 4.32%.  All sectors of the stock market were down sharply with only 27 stocks in the S&P500 having a positive return in September.  Interest rates moved higher with the 2-Year Treasury yield climbing above 4.3% after yielding less than 0.3% just a year ago.  The rise in yields is bad for existing bonds as their prices adjust (fall) so that their yield reflects prevailing rates.  However, their prices will converge back to par assuming there is not a default.  Slowing economic activity from higher rates may increase the probability of a default as it could make interest and principal payments harder for borrowers. 

The silver lining from higher rates is higher yields in bonds and lower valuations in stocks.  Investors are finally earning a return on their cash and relatively attractive yields on their bonds.  With stocks down over 20% both in the US and abroad for the year, the high valuations that we experienced in the past few years is no longer an impediment to put money to work.  It should also keep long-term investors focusing on the long-term.  The Fed will eventually stop raising rates as it isn’t hard to predict what 7% mortgage rates will do to house prices and all the industries associated with new home construction.  Clearly the Fed was too late to the game to pull the punch bowl away and the markets will remain volatile until we get inflation under control.  The Fed does has some ammunition to cut rates in the event that we do see a sustained recession from tighter financial conditions.  The bond market is already pricing that in with an inversion in the yield curve: higher yields on short-term bonds than longer maturities. Sticking to long-term plans is difficult in times like these but trying to time the market with any level of consistently is most certainly harder.

Sources: Morningstar Direct, Wall Street Journal, State Street, St. Louis Fed database