What started as a strong tone from the Fed, has translated to turmoil in the global financial markets, as Federal Reserve Chairman Jerome Powell and James Bullard, President of the Federal Reserve Bank of St. Louis unleash panic, verbalizing the need for rapid rate hikes to combat inflation. Although 2021 closed out with the S&P 500 up 26.89%, 2022 has served a wake-up call to conservative investors, as U.S. Government Bonds believed to provide immunity from volatility, are down year-to-date over 10%, while the S&P 500 has fallen -12.8%. Recessionary fears are no longer a headline, as Q1 GDP declines to 1.4%, a sharp reversal from a 6.9% annual growth rate in the fourth quarter.
Since 1977, the Federal Reserve has operated under a mandate from Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates". With the Fed focused on run-away inflation, an issue at Samra Wealth Management we believe to be transitory and to subside later this year, they have pivoted to fight inflation and reducing demand, demand investors believed would be pent-up from covid lockdowns. As the Fed focuses on combatting inflation by increasing key interest rates, investors should understand the cause of recent inflation was related to supply-chain and the incursion into Ukraine, not related to low-interest rates, as the chart below depicts.
Although the U.S. economy has shown resilience, Powell’s two-dimensional strategy is overcompensating, from doing too little too late. In our August 2021 issue of The Samra Report we wrote the following forecasting the strength of the U.S. Dollar, short-term inflation, and the impact of interest rate hikes:
In a domestic economy, should the central bank raise interest rates, relative to foreign economies. The domestic economy in this case would experience an influx of capital, pushing up the relative strength of the domestic economy’s currency, offsetting foreign trade. In our current scenario, low interest rates help to ensure domestically produced goods are accessible in global trade. At Samra Wealth Management, we believe interest rates will start to tick-up in November, due to an announcement by the Treasury, it could begin cutting the size of government debt sales in the fall, as funding needs for economic relief efforts ease, in a move that would pave the way for the first reductions in five years. We believe the Fed is likely to follow suit in its April meeting, as talks of tapering start to solidify.
A rise in interest rates, combined with a tax increase could deal a blow to select sectors in the near term, specifically: Healthcare, Technology, financials, industrials, and consumer discretionary, prompting a change in our sector rotational strategy. However, although we expect interest rates to rise moderately in Q4 into Q12022, we believe the Fed’s plan will be contingent on unemployment, as it emphasizes returning to pre-pandemic levels, while keeping an eye on run-away inflation. We expect short-term inflation to increase, given pent up demand and supply-chain constraints due to logistics and shortages. We further expect the above-mentioned sectors to recover swiftly given the go-ahead of an infrastructure spending bill, and increased stimulus measures.
Conservative investors in search of yield, in an interest rate environment where the 10-year fell below 1.14% in July, and the real interest rate (10-year U.S. Treasury indexed for inflation) fell to -1.19%, a multi-decade low, need to rethink their investment strategy. (Fred.stlouisfed.org) A conservative allocation weighted heavily towards fixed income, places these investors at increased risk, as interest rates start to rise while prices of bonds fall. At Samra Wealth Management, we expect increased volatility across asset classes over the next 12-months, suggesting a managed strategy is likely to outperform that of passive investments.
In April we stated: “we believe the Fed’s approach to monetary policy is too little, too late, and an attempt to play catch-up could send the US economy into a recession.” While the Fed focuses-in on controlling inflation, at Samra Wealth Management we believe there are two components flying under the radar: (1) a strengthening dollar, and (2) the U.S. Labor market.
Year-to-date the dollar has surged 8% to its highest levels in two decades, as investors ramped up bets that aggressive interest rate rises from the Federal Reserve will leave other central banks trailing far behind. The dollar's appreciation is leaving a trail of destruction in its wake, exacerbating inflation in other countries, and tightening financial conditions just as the world economy confronts the prospect of a slowdown in growth. (Reuters) Domestically, the United States in the short-term could benefit, as a stronger dollar benefits the buy-side of the equation with regards to foreign trade, however, as U.S. exports become more expensive in relative terms, global demand for U.S. goods and services could fall to a multi-decade low. In our January edition of The Samra Report, we issued a “recommendation focusing on domestic holdings with little exposure to foreign exchange risk.” A strengthening dollar not only weakens trade, however, impacts domestic corporations yielding revenue from abroad. This becomes concerning for corporations accepting foreign currency, where the cost of bringing dollars back to the US becomes more expensive. Think of companies such as Walmart, McDonalds, and Starbucks, with vast international operations, there is significant risk in foreign exchange. This scenario also impacts foreign trade as American goods become more expensive to foreign consumers.
According to the Wall St. Journal: “The Labor Department on Tuesday reported a seasonally adjusted 11.5 million job openings in March, an increase from 11.3 million the prior month. The number of times workers quit their jobs rose to 4.5 million in the same month, slightly higher than the previous record in November of last year.” Although enhanced unemployment benefits may have delayed some employees from returning to the workforce, at Samra Wealth Management we believe the “great resignation” is fueled by the work from home and hybrid models. During the lockdown, employees were afforded the freedom of time, time saved commuting to the office and no-longer having someone looking over your shoulder. Although speculation, we believe this may have increased the pace employees converted their part-time gigs to full-time business operations. We do not believe there has been a mass exodus from the workforce, and alternatively we are seeing mass migration by entrepreneurs, our consensus strengthened with the below data from the Bureau of Labor Statistics.
As employers incentivize the workforce, we may end up experiencing the textbook definition of wage-push inflation: the general increase in prices caused by wages rising in society, prompting the Fed to again tighten the money supply, testing the resilience of the U.S. financial markets.
This material is provided as a courtesy and for educational purposes only. This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results.
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Chaney Cambon, S., 2022. U.S. GDP Falls 1.4% as Economy Shrinks for First Time Since Early in Pandemic. [online] WSJ. Available at: <https://www.wsj.com/articles/us-economy-gdp-growth-q1-11651108351> [Accessed 28 April 2022].
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Reuters.com. 2022. U.S. Treasury sees economy still expanding in 2022 despite Q1 GDP drop. [online] Available at: <https://www.reuters.com/world/us/us-treasury-sees-economy-still-expanding-2022-despite-q1-gdp-drop-2022-05-02/> [Accessed 2 May 2022].
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Stubbington, T., 2022. Dollar surges to highest level in 20 years. [online] Ft.com. Available at: <https://www.ft.com/content/54f5231e-6157-4312-b3e4-a74335ca9bcc> [Accessed 28 April 2022].
*Last Updated May 4, 2022.