Introduction
There’s a lot happening in financial markets. We’re here to help you cut through the noise and focus on what’s most important.
At BlackRock, the largest asset manager in the world, we often get asked – what do you think? On each episode, we’ll try to answer that question, and give you a simple story.
This podcast is intended for investors who partner with a financial professional – what we like to call the advised investor. I’m your host, Dennis Lee - welcome to BlackRock’s In The Know Podcast.
How We Got Here
Today’s market story is called Staring Down the Mountain.
According to most economists, we may be at peak inflation, and closing in on peak rates.
Since 1926, average inflation per year was around 3%. Three big factors, among several, kept inflation down below 2% on average for the last decade. Globalization meant more efficiently produced goods and more choices for consumers. Technology improvements meant improved value for consumers. And increased price transparency meant that you could now find the cheapest price almost anywhere in the world – which keeps prices down.
The U.S. Bureau of Labor Statistics estimates that the adjusted price for TVs decreased by 94 percent from December 1997 to August 2015. Ever try to resell a TV that’s even a few years old? Super difficult. Of course, not everything is like a TV – education, healthcare, and other sectors have all inflated. But all of that got averaged into a low, overall inflation number.
Then came 2021 and 2022. First, we saw a significant shift in consumer spending to goods (e.g. household items) vs. services (e.g. transportation, restaurants). This created historically high bottlenecks and constraints on manufacturers and supply chains.
Second, we saw homebuyers capitalizing on historically low mortgage rates. The lower the rate, the more buyers could afford, driving the price of homes upward. Housing comprises more than 40% of the inflation index.
Third, the ongoing crisis in Ukraine is not only a humanitarian tragedy, but perhaps one of the most significant geopolitical events of our generation. It accelerated this trend of geopolitical fragmentation. Countries are increasingly seeking economic independence from a previously more intertwined global system – further hampering companies’ ability to produce and sell goods efficiently.
Last, and perhaps most significant – the crisis in Ukraine restricted the world’s access to oil in Russia. While the U.S. is relatively energy independent, the restricted supply of oil across the globe increased prices everywhere. Energy impacts everything we do, from transportation, shipping, and living in our own homes. The more it costs for your grocery store to bring goods to the shelves, the higher those prices will be.
The Fed Steps Up
The biggest story of the year – inflation – is directly related to the second biggest story of the year – the Federal Reserve’s response. The Fed has two goals. (A fancier way to say this is that they have a dual mandate.) Their job is to keep prices stable (or keep inflation manageable), and keep employment in the U.S. strong.
The Fed influences the Fed Funds rate, which is its main lever for reducing inflation. By raising rates, they make it more expensive to borrow money, whether it’s for a home, car or a business loan. This in theory makes people more selective in their spending, bringing prices down. However, raising rates could slow down spending and business growth too much – potentially creating unemployment and tipping us into a recession.
And yet, as the Fed raised rates, jobs remained fairly stable. The much covered tech layoffs represent only a small percentage of the total job market, and it’s possible it could be foreshadowing more to come – it’s just too early to tell if and when that will happen. And because inflation was caused by a myriad of factors of which the Fed does not have total control, inflation remained stubborn and the Fed continued to raise rates more aggressively than anyone thought.
Where We Are Today
Well, perhaps it’s now finally going to plan. Because while inflation is still relatively high, it looks like we may have hit a peak last October. The Fed has already slowed the pace at which they are raising rates. And while just a few days ago at the Federal Open Market Committee meeting (that’s FOMC for the acronym enthusiasts), the Fed raised rates again by a .25%, most economists are wondering whether are getting close to a peak.
But uncertainty looms large. Has the Fed done too much? Will the U.S. economy fall into a recession? Can companies sustain their business models in a high rate environment?
Market Story – Staring Down the Mountain
With all these questions floating around, it can be hard to know how this all affects your portfolio. To try and explain our views in a nutshell, here’s that story I promised – Staring Down the Mountain.
We’re effectively at the mountaintop of inflation and rates, and we are looking down onto an uncertain road. Imagine yourself on top of a snowy peak. The weather is treacherous. You’re bundled up in a thick, winter coat, but it doesn’t feel like enough. And while it’s unclear how to get down safely, you want to find the best pathway down.
Here are a few things we do know.
First, recognize that higher rates mean higher yields for bonds. For the first time in years, your portfolio can generate income at relatively low risk. As of the end of January, short-term corporate bonds are yielding close to 5%* - well above the close to 0% yields just a few years ago. These higher yields are effectively like snow boots with great traction. You can make pretty good progress down the mountain at lower risk.
Second, value stocks look relatively attractive. The last decade has been marked by unbelievable growth and conditions for fast-moving companies. If this were two years ago, the mountain would have seemed gloriously sunny with fresh powdered snow, and you would have had the best skis in the world for a thrilling and rewarding ride down. But we saw that that strategy ended with a pretty bruising crash. Historically, value has outperformed growth following rate hikes, likely because they rely less on borrowing money for leverage and high speed growth. Over the long-term, value stocks may be able to give you a steadier, if less thrilling, ride.
And third, sitting in cash, or on the sidelines, is likely the worst strategy. Inflation will eat away at your money the way the cold might slowly eat away at your resolve.
What Should I Do?
It’s still unclear where markets will go. Nobody has a crystal ball. But there are adjustments you can make to help maximize your chances for success. If you believe that economic growth is likely to slow and that stock prices are not fully reflecting the impact of slower growth, consider taking a defensive tilt in your stock allocation, and consider overweighting bonds over stocks. Take one step in front of the other with your snow boots.
If you believe that the worst is over, you may want to get down faster and enjoy the ride. But the weather can be unpredictable, so ensure you’re doing what you can to manage your risk. Value may be a helpful tool.
And if you think there’s too much uncertainty right now to formulate a view, you are not alone. There’s no shame in not knowing, just don’t leave cash sitting on the sidelines when it could be generating income through bonds.
Closing
So if you want a quick talk track on what’s happening in markets, here it is in a nutshell.
Inflation led to the Fed rapidly raising rates, which led to a challenging environment for stocks and bonds. But as inflation seems to have peaked, rates may be peaking as well. And we’re not exactly sure what the future holds at this mountaintop. So the question for investors is – how do I navigate this period of uncertainty? Facing peak inflation and peak rates, what tools do I have at my disposal to navigate risk, and make my way to safer terrain?
Take advantage of higher bond yields.
Lean into value over growth.
And whatever you do, don’t sit on the sidelines
Talk to a financial professional and adjust accordingly.