IT is the top preoccupation of 2022 where the financial markets are concerned: Watching the Fed.
To add to the fanfare, the key speech delivered by Federal Reserve chairman Jerome Powell on August 26 was live-streamed for the first time since the beginnings of the Jackson Hole symposium, a key annual gathering of central bankers. It was a nod to Powell's commitment to communicating directly with ordinary Americans.
In his first paragraph alone, he promised remarks that would be "shorter, my focus narrower, and my message more direct" than past speeches he had made at the closely watched event. To restore price stability, it will take some time and the Fed using its tools "forcefully" to bring demand and supply into better balance. That means that the Fed will not, as some in the market had expected, lighten up on its rate hikes.
Call it sport or spectacle, but the 8-minute speech pushed the S&P 500 down by more than 5 per cent in the three trading days after the speech was delivered. Nasdaq fell close to 7 per cent over the same period. By Bloomberg's estimates, the market tumble wiped out US$78 billion from America's richest people.
Why are the stock markets so jumpy? The 46 times that Powell utters the word "inflation" is the whodunnit clue flashing in neon lights. The aim of the speech was to simply state that the Fed is single-mindedly focused on controlling inflation. To bring inflation down will likely require a sustained period of below-trend growth, softer labour market conditions and consequently, some pain to households and businesses.
After a decent bounce in markets across the summer, the pointed comments have set off a new cycle of bearish takes that was prevalent in the earlier months of this year. Market sentiment is swinging through extremes - being highly reactive to the words and actions of the Fed - as it switches from bearishness to bullishness and back to bearishness again.
There is a circular argument going on here - we went through it and we are now back at the top again. It goes something like this:
- Powell and the Fed are serious about fighting inflation and they will tighten for as long and as much as necessary to tackle and bring down inflation. That is bad for markets.
- This means that the risk of recession is rising and that will cause demand to drop, hurting the economy and earnings. That is really bad for markets.
- Weaker market and economic data will mean the Fed will not have to worry about inflation anymore and can stop raising earlier, and even possibly start cutting rates. That's really good for markets.
We just rotated from point 3 to 1, and with every new Fed comment and economic data, we will keep going round and round..
One major fallout from the recent move higher in market interest rates is the performance of global bonds, which have now officially entered its first bear market in decades.
Specifically, the Bloomberg Global Aggregate Total Return Index of government and investment-grade corporate bonds has fallen by more than 20 per cent from its 2021 peak on an unhedged basis - the most since the index's 1990 beginnings.
Such headlines may stir some panicked responses at first glance. But what's interesting to see is that in fact, the bond markets reacted in a rather muted fashion to Powell's Jackson Hole speech as compared with the equities markets.
The nub of the current conundrum is in timing, and that is guided by the answers to a few key questions about the world's largest economy: When will inflation peak? When will growth turn negative? When will the Fed cut rates?
By definition, fixed income investors are top-down investors who focus on tracking macroeconomic data such as inflation, interest rates and monthly economic data. Equities or stock investors are bottom-up investors who zoom in on microeconomics or individual companies' performance.
Despite the big looming questions about the US economy, the latest market movements tell us that the bond markets have already priced in a certain future expectation, with Treasury yields well above 3.5 per cent - depending on the maturity - compared to the Fed, which is still at about 2.5 per cent and playing catch up.
With rising interest rates, the bond market takes a negative hit, but there may yet be opportunities for investors in the space. The repricing of bonds, once the price impact is over, will allow investors to take advantage of the higher interest rates to reinvest into higher-quality bonds with the same or better yields. As long as the weaker economy doesn't damage credit quality, and we do not see a major increase in defaults, which doesn't seem likely at the moment, the normalisation of the bond market may be nearer.
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Meanwhile, the heightened volatility in equity markets suggests that investors are focused on the intentions of the Fed, and taking bets on the central bank's future behaviour. The uncertainty has left investors looking for quality and dividend stocks that are likely to demonstrate defensive qualities. Since these companies are expected to have strong balance sheets, they can both weather weakness in economic growth and be sheltered from higher borrowing costs.
All that said, the market has already told us where the Fed is likely to be headed and the Fed is quite transparent through their dot plots and guidance. So the variability of outcomes is likely to be narrow. Does it peak at 3.5 per cent or 4 per cent, and does the Fed rate peak in Q1 or Q2 next year? The outcome is unlikely to be a major surprise. While financial geeks may have found a new sport from watching the Fed tighten rates amid high inflation after more than a decade of quantitative easing, it may end up being as exciting as watching paint dry.
The trillion-dollar global bond market remains efficient at pricing in future expectations pretty quickly. Bottom-up investors meanwhile will keep trying to forecast macroeconomic directions and to rework their models to find the right target prices for stocks in these times. But most often they too are chasing the market down, and they will likely miss the bottom and chase the market back up again. When markets are volatile, it normally means that there is no consensus and if there is, then the consensus is likely to be wrong. There has never been a consistent way to predict the future direction of markets.
So instead of fretting over every word from the Fed chair or the minutiae of market volatility, investors can - and should - focus on the long-term macroeconomic trends and long-term secular market returns, and to cut through the noise of the current cycle. Be clear about your specific financial priorities and goals, depending on your current life stage. Then commit to securing returns for the years ahead by adding to your investments in a consistent and patient manner. Instead of trying to solve the macro conundrum by timing the market, let efficient markets solve it for you through time. The aim of investing is not for us to react to volatility, but to find peace of mind in spite of it.
The writer is chairman and chief investment officer of Endowus.com, a fee-only digital wealth platform for all your wealth - CPF, SRS & cash savings.
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