Market Outlook: Push Pause?

Core CPI, a measure of inflation that excludes food and energy and is reportedly one of the Fed board's preferred inflation indicators, has retreated from its peak of well above 6% but remains notably above the 2% target level. The best that can be said is that inflation is trending downward while still being elevated. This raises hopes that the Fed may soon be able to ease off its rate-hiking campaign, if it hasn't already. If the Fed board decides not to raise rates on November 1, following their decision to keep rates unchanged in September, it would mark the first time in the current cycle that they have declined to raise rates at consecutive meetings. This would likely be interpreted as further evidence that the current rate hike cycle is ending and that the official "Fed pause" has arrived.

While market futures pricing and many Fed board members anticipate lower rates in the future, this is not guaranteed. Bringing inflation down from its peak was likely the easy part; reducing it from its current elevated level to the Fed's 2% target will likely be more challenging, as businesses raise prices with little negative impact on sales and workers demand higher wages nationwide. The chart below depicts the current market expectation for the Fed policy rate (dashed green line), while the dots represent the expectations stated by individual Fed board members. Although they are closely aligned now, note the dispersion range next year, indicating that not all Fed members believe rates will indeed be lower a little over a year from now.

The broad bond market is one area that has experienced immediate negative repercussions from Fed policy. This asset group, typically considered the least volatile and most reliable segment of the investment market, is on track for an unprecedented third consecutive year of principal losses. Widely used as the "defensive" portion of an investment portfolio, it's rare for this category to lose money alongside stocks, especially to the extent recently witnessed. The Bloomberg Aggregate Bond Index, shown in the chart below, tracks the US investment-grade bond market similar to how the S&P 500 tracks the US large-cap stock market. After falling 13.9% in 2022, the Bloomberg Aggregate Bond Index was down another 5.4% in 2023 as of 10/3. Before 2022, the largest one-year decline in the index since 1976 was just 3.92% in 1981. One year of a significant drop was remarkable, but two consecutive years is an unprecedented event. Like mortgage rates, this is another financial product caught in the interest rate hike feedback loop.

Bond selloffs result in higher interest rate bearing debt, indicating higher future borrowing costs. Like existing homeowners with mortgages, many corporations secured low interest rates during the historically low-rate environment of 2020-2021. While large companies haven't yet felt the full impact of the Fed's rate hikes, they will eventually when they refinance their current debt. Year-over-year changes in interest expenses for S&P companies (the collective interest payments on corporate debt) are already rising at one of the fastest rates on record, albeit from a low nominal level. This is impacting smaller companies more severely than larger ones. Floating-rate debt (debt with interest that automatically adjusts to market rates) accounts for approximately 30% of Russell 2000 firms' debt (an index of smaller capitalization U.S. companies) compared to 6% for the S&P 500, and Russell 2000 companies typically carry higher debt levels than their larger counterparts in the S&P 500.¹

Markets could face challenges in the near future if rates remain elevated or increase further, as maturing debt (debt that must be repaid) will roll over from past low rates to current high rates. This phenomenon, known as the "debt maturity wall," could make refinancing cheap debt into more expensive debt unsustainable for some companies, as over a trillion dollars in corporate debt matures annually over the next five years.

Don’t Abandon Bonds

The Fed's inflation-fighting measures through higher interest rates have caused bonds to experience historically poor performance in recent years, leading some to question their effectiveness as a "defensive" portfolio position. However, if we are at or near a Fed pause, history suggests that bonds should rebound once the threat of further rate hikes recedes. As the chart below illustrates, bonds have responded favorably as a group following the last four rate pause instances. While it's premature to declare a pause, history indicates that patient bond investors were rewarded in similar environments.

Additionally, long bond market sell offs are very rare. Since 1926 (through April 2022), the broad bond market has only sold off over a 3-year period in 1% of the trailing period examples and never for a four-year period. Even if the current situation becomes the first instance of a four-year bond sell-off, historical data suggests that the bottom of this down cycle is likely approaching.

In contrast to bonds, stocks historically exhibit a wide range of outcomes following a Fed pause. S&P performance since 1929 has been inconsistent, with outcomes largely dependent on the context of each historical period, and the average outcome being relatively flat over the subsequent year. This information, combined with the bond market's historical behavior, suggests that the post-Fed pause environment is more predictable and favorably positioned for bonds than for stocks.

The Inflation Outlook

The potential obstacle to a rate hike pause is the possibility that inflation has not been fully subdued. While it has retreated from last year's highs, it remains significantly above the Fed's 2% target. As your CWM team cautioned in our analysis of the potential for resurgent inflation earlier this year, recent data showing three consecutive months of accelerating core inflation readings suggests that inflation may not be vanquished. While this uptick in inflation pressure could be temporary, it undoubtedly raises concerns among Federal Reserve decision-makers.

What to Do with This Information

The incorporation of the aforementioned data into portfolio decision-making depends on the strategy being implemented (see CWM strategy table below). Passive models (blue-headed columns) can disregard the discussion of inflation and its feedback loops, as their primary focus is adhering to the discipline of each model. Extended Savings account investors (with dollars specifically in a money market) should maintain their focus on the adequacy of the income being generated, while those in Wealth Accumulator Models should continue making contributions to their accounts based on their financial plans, regardless of market fluctuations. The latter group should prepare for increased market and portfolio volatility, which may challenge their composure and patience. For investors in active models (orange-headed columns), the information presented above forms part of the current investment environment and factors into the analysis of the current investment market, as depicted in the CWM Factor Groups below.

In context of current data outlook, a pause in Fed activity likely doesn’t represent a positive for stocks, and potentially is a negative. Pausing could be construed as an admission that economically something was starting to break, and that the Fed was responding to that problem by lowering the cost of borrowing. For active models, the period surrounding a Fed pause historically favors bonds and income-generating assets. However, resurgent inflation could compel the Fed to resume rate hikes, which would negatively impact income-producing assets. Given the likelihood of an imminent or near-term Fed pause following an already aggressive rate-hike cycle, it would be imprudent to entirely abandon bond positions, despite elevated price volatility in the sector. On the other hand, persistent inflation, with recent signs of acceleration, raises the risk of further Fed rate hikes, which could hurt bond positions. Additionally, the current environment indicates significant downside risks for the overall stock market, necessitating defensive positioning, such as bonds. Isn’t investing fun?!

Taking the above factors into account, the current objective for active portfolios, as reflected in recent portfolio trading activity, is to maintain a balance of defensive assets in anticipation of a Fed pause and market-neutral assets that are indifferent to rate movements or can offer upside potential in a rising inflationary environment. This balanced approach can help alleviate the heightened market volatility of recent years and provide income while awaiting greater market clarity regarding the Fed pause and other significant market-moving global events. No matter how markets move, CWM clients can rest assured that we will remain disciplined in the application of the strategy selected for their accounts.

The current economic landscape presents a complex and dynamic environment for investors. While a potential Fed pause could provide a favorable backdrop for bonds and income-generating assets, persistent inflation and the risk of further rate hikes require a cautious approach. Investors should brace for continued market fluctuations, align their investment decisions with their risk tolerance and long-term objectives, and maintain a focus on long-term goals rather than short-term market movements.

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P.S. Spooky season is upon us and one of my family’s favorite traditions is watching all the Ghostbusters’ movies and the cartoon series from the 80s. For those wondering, the movies hold up well and the kids’ cartoon… well it’s still fun to see my kids enjoy it. Because of that, this house wins our vote for the best Halloween decorations.