It appears the Federal Reserve is determined to crash the economy in order to stamp out inflation. They will likely succeed, but at what cost?
In the face of an already-slowing economy, the Fed pushed its Fed Funds rate higher by another 0.75% on September 22nd and indicated that they will increase this rate by another 1.0%-1.25% by the end of the year. Inflation is the bogey-man, and it must be defeated, regardless of the collateral damage.
In fairness, the Fed is right. Persistently high inflation corrodes an economy and limits its potential growth. No economy can perform well with high inflation and the U.S. is no exception. However, the threat is that the Fed will inflict more economic pain than is necessary to tame inflation. That is, the Fed may push the economy into a severe recession by acting too swifty and too aggressively.
Already the index of Leading Economic Indicators has contracted on a month-over-month basis for five consecutive months. Going back in the index’s history to the 1960s, it’s rare to see a contraction lasting this long without shortly entering—or already being in—a recession. Furthermore, the global composite purchasing managers’ index (PMI), a timely indicator of global economic activity, fell 1.5 points in August to 49.3—its first dip below 50 since 2020. Any reading below 50 suggests economic activity is shrinking.
The Crystal Ball
Okay, there is no crystal ball, but one of the best predictors we have is the bond market. And the bond market seems to be saying that the Fed is being too aggressive and that they will be forced to reverse course at some point.
The graph below is the Treasury yield curve which plots Treasury yields across the different maturities. During more normal economic times (like September 2020 and 2021), yields gradually increase as maturities get longer. However, the current yield curve is inverted, meaning that longer-dated Treasuries are yielding less than short. Currently, a one-year Treasury yields more than 4%, but a 30-year Treasury yields less than 4%.
Why would investors lock in a yield for 30 years that is less than they would get for only one year? Simply put: they don’t believe the higher short-term yields will last. Or put another way, the bond market is predicting that the Fed will be lowering rates during the next few years thus bringing down short-term Treasury yields.
If the Fed is forced to lower rates in response to a recession, investors are likely to see the market rally–even in the depths of a recession. After all, the stock market is a forward-looking indicator that tends to predict economic conditions six to nine months out. And if the Fed is stimulating the economy, the results of the stimulus take months to work through the economy.
This type of credit cycle has been repeated many times in the past. Most recently, the economy collapsed in the spring of 2020 due to the pandemic. The Fed responded quickly, slashing rates and boosting liquidity. To the surprise of many if not most, the stock market took off like a rocket. No one knows exactly what this credit cycle will look like, but it is well established that an accommodating Fed is good for the markets.
So where does all this leave investors?
The S&P 500’s forward price-to-earnings (P/E) ratio has collapsed this year (though it remains elevated relative to its longer-term average, as well as to levels seen during prior bear market lows). Conversely, the S&P 500’s forward earnings yield is still trading comfortably above the 10-year U.S. Treasury yield and is far from its most overvalued level in history (seen during the height of the tech bubble in the early 2000s).
Given these measures, it’s hard to say stocks are either overvalued or attractively priced. The reality is that at any point in the market cycle, bullish and bearish investors can find metrics that suit their outlook on the market.
Instead of focusing on whether to buy or sell stocks in the current environment, a better approach might be to refocus on a portfolio strategy for the long haul. In times of volatility and uncertainty, taking a step back can often be very helpful. Regaining perspective can help us avoid emotional decisions driven by the vagaries of the economy and the stock market.