This is an especially tricky time for the markets. The conditions that led to the tremendous run up in asset prices (low interest rates and inflation, combined with strong growth) have now flipped. Inflation is running hot, and the Fed is scrambling to raise rates and slow demand before inflation becomes endemic.
Low interest rates are beneficial and supportive to stock prices. Conversely, higher rates (like we are experiencing now) hurt stocks. The reason why boils down to what is known as the risk-free rate of return, which is basically what an investor can earn in cash, CDs, or short-term Treasury bonds. Basically, what can an investor earn with no risk. If the Fed sets interest rates at 0%, then the risk-free return is 0%, and investors look to more attractive (and risky) options like stocks, real estate, cryptocurrencies, etc. But when the Fed increases the risk-free rate of return, the value of risky investments must be discounted lower.
To use a simple example, if an investor could earn 10% on a CD, then why bother with the stock market? Or, if that investor did decide to forego the 10% CD, and instead invest in stocks, then they would be expecting to earn more than the 10% they are giving up. And to accomplish that, they would need to get a very good deal (low price) on the stock purchase. This is just to say that stock valuations get crushed when the risk-free rate of return becomes attractive to investors.
And Don’t Forget Credit
The previous examples were illustrating the choices investors make about where to put their dollars. Earning 0% is not attractive. This is a given. But what about borrowing money at near 0%? This is obviously a very different, and much more attractive proposition. Now, imagine you are a big financial institution. Wouldn’t it make sense to borrow at very low rates and put the money into the raging stock and real estate markets? Yes, it would. That is, until it didn’t .
Investors large and small have been pulling dollars (either earned or borrowed) out of stocks and other risky assets causing prices to fall. The extensive use of cheap borrowed funds in the leadup to 2022 both magnified the rise and is magnifying the decline.
The Slowdown Has Begun
The stock and bond markets are down considerably from the beginning of the year. Residential real estate has also cooled with 30-year fixed mortgage rates spiking from under 3% last year to more than 5% today. For a $500k mortgage, the difference in monthly payment between a 2.75% mortgage and a 5.5% mortgage is over $800-per-month!
This is how the Fed slows the economy. Just like that, $800 from this homebuyer’s monthly budget is gone and not available to spend on other things.
With housing, autos, food, and travel all more expensive, there are less dollars for other expenditures. Lower overall demand means slower growth and possibly a recession. In fact, we may already be in a recession.
Inflation is Key
Seemingly, the Fed has made a choice: chronic inflation is not acceptable and must be dealt with swiftly…even if it means recession. And this is where we find ourselves today. If the Fed is successful in lowering inflation, then it can turn its focus to stimulating the slowed economy through lower rates and the stock market will likely respond favorably.
In the meantime, all eyes will be on inflation. Should inflation slow, markets will likely see this as an indication of a change in Fed direction. However, should inflation remain elevated, and interest rates continue to rise, stocks are likely to suffer even more.
Bull Market Somewhere? Yes!
When the headlines are focused on the collapsing stock market it is important to remember that SilverPeak Wealth invests in more than stocks.
What tends to do well during inflationary periods? Hard assets. Historically, real estate and gold have both been good hedges against inflation. SilverPeak Wealth prefers real estate to gold because it offers an attractive dividend yield.
Our preferred real estate investment, the Blackstone REIT (BREIT) is up 6.5% so far this year, which is quite attractive in the current environment. And an important reminder about the power of diversification.
Illustration by Charlos Gary. © 2021 Charles Schwab & Co., Inc.
THIS POST IS GENERAL IN NATURE AND MEANT FOR INFORMATIONAL PURPOSES. IT SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE. ALL INVESTMENT STRATEGIES AND INVESTMENTS INVOLVE RISK OF LOSS. ANY REFERENCE TO PAST OR POTENTIAL PERFORMANCE IS NOT A RECOMMENDATION OR GUARANTEE OF ANY SPECIFIC OUTCOME OR FUTURE RESULTS.