I hope this letter finds you well and thriving. We appreciate the trust and confidence you have placed in us to manage your investments. As we approach the end of the third quarter, we wanted to provide you with insights into the current economic and market landscape, as well as our outlook for the coming months.
In 2022, the prevailing sentiment regarding the Federal Reserve has seen a remarkable transformation. It has shifted from the notion that “The Federal Reserve is behind the curve on inflation” to the concern that “The Federal Reserve is at risk of going too far and causing a recession.” This evolution in perception underscores the dynamic nature of the financial markets.
A major factor contributing to this change has been the Federal Reserve’s historic pace of interest rate increases. Over the past year, they have raised rates by 5.25%, making it the fastest rate hike in history. This is consistent with traditional economic theory, which teaches that the Federal Reserve raises interest rates to slow the economy. Higher interest rates are designed to make borrowing more expensive for individuals and corporations, which, in turn, slows spending and helps bring down inflation.
Since the Great Financial Crisis, the Federal Reserve has maintained an “accommodative” stance on interest rates, keeping them below the inflation rate. This approach not only maintained interest rates at 0% but also involved active buying of bonds, known as Quantitative Easing, to stimulate the economy. However, in March 2022, the Federal Reserve shifted towards a more restrictive policy, where interest rates exceed the inflation rate, creating a current Fed Funds rate that is restrictive by approximately 2%.
Surprisingly, despite these record-breaking interest rate hikes, the economy continues to expand, keeping inflation persistent. The Federal Reserve’s commitment to keeping rates “higher for longer” until inflation is under control implies their intent to maintain rates in a restrictive territory until the battle against inflation is won. Nevertheless, this strategy carries the risk of unintentionally slowing the economy to the point of recession and increasing unemployment.
The challenge of orchestrating a “soft landing,” in which inflation decreases to the target of 2% without triggering a recession, is a complex one. The Federal Reserve’s primary tool, interest rates, may seem blunt in addressing this task.
Higher interest rates, though, have had a limited impact on consumer spending due to the fact that many homeowners took advantage of historically low rates to secure 30-year mortgages at around 3%. This means that higher mortgage rates have not significantly affected a substantial portion of consumers, who are protected from potential future rate increases.
It is essential to understand the historical context of the Great Financial Crisis in 2008, which served as a contemporary version of the Great Depression. The latter originated from the government’s response to the post-stock market bank collapse, which included raising tariffs and interest rates. Although policies were eventually reversed, the damage was done, and the Depression persisted. Only the massive spending and job creation during World War II finally rescued the U.S. economy from its clutches.
The Great Financial Crisis of 2008 did not escalate to the level of the Great Depression because the government implemented contrasting measures: lowering interest rates, increasing spending, and supporting the banking sector. However, economic activity remained weak, and deflation, similar to that experienced during the Great Depression, persisted.
It was not until the economic equivalent of World War II, the COVID-19 pandemic, that both monetary and fiscal policies were fully unleashed on the economy, transitioning deflation into inflation and stimulating economic activity.
The analogy that comes to mind when contemplating the COVID-era stimulus and the post-COVID restrictions is that of an engine being primed with starter fluid. Initially, the economy needed a boost, which was achieved through stimulus measures. However, it accelerated too rapidly, and now the challenge is to manage the pace to ensure it remains sustainable.
As we approach the conclusion of the third quarter, we observe that stocks are beginning to wane, while interest rates are on the rise. The question on the minds of many investors is whether stocks will continue to decline, and if rates will continue to ascend. Our perspective suggests that the answer is “yes,” but not for much longer.
Many market strategists anticipate that the S&P 500 Index could dip to 4,200 before turning higher, while our view is that the turning point is closer to 4,000. During this period, interest rates could experience an increase, with mortgage rates potentially spiking to 7.8% and the 2-year Treasury bill spiking to 5.5%.
At these levels, we believe both stocks and bonds will present attractive opportunities for investors searching for bargains. From here, we anticipate stocks rallying to all-time highs while interest rates start to soften.
We believe that the Federal Reserve is approaching the end of its efforts to combat inflation. While there may be one more rate hike in November, we anticipate that this will be the final hike from the Federal Reserve. Several factors influence our perspective:
- a) The ongoing UAW strike.
- b) The potential impact of a government shutdown.
- c) The presence of higher interest rates.
- d) Data confirming that inflation is gradually decreasing.
- e) The implications of student loan payments resuming.
- f) A slowdown in the housing market.
While the Federal Reserve continues to emphasize its “higher for longer” stance on the Fed Funds rate, we believe they are closer to considering rate cuts than many are predicting. They find themselves in a challenging position, needing to prevent investors from prematurely anticipating rate cuts, which could undermine the effectiveness of higher rates. Therefore, we anticipate that the Federal Reserve will maintain the appearance holding rates “higher for longer” yet their decision to cut rates will come like a thief in the night.
The most recent example of such a swift shift in Federal Reserve policy came at the end of 2018. During the Q&A session following the December 2018 meeting, Chairman Powell stated clearly that the Fed would likely HIKE rates twice in 2019. Only a few weeks later, Chairman Powell told investors that the Federal Reserve did not want to become “part of the problem”, when referring to the sluggish recovery, and therefore the Fed would not hike rates any time soon. By the end of 2019, the Fed had NOT hike interest rates 2 times as was expected to begin the year. Instead, the Fed ended up CUTTING rates 3 times in 2019 and another 2 times in 2020.
As the third quarter has progressed, we have been net sellers of stocks in our managed accounts for clients. During this time, our Investment Committee has been diligently researching stock and bond candidates for potential investments. We expect to shift from being net sellers of stocks to net buyers of stocks by the end of October.
In the coming weeks we expect the “fever” of lower stock prices and lower bond prices (higher interest rates) to break. Once this “fever” breaks, it could mean that markets fall further before settling down. If we see this play out, our response will be to buy into both stocks and bonds, based on the Strategy, bringing our cash position down to fully invested levels.
While short-term volatility is likely to persist, our conviction is strong that stocks will experience significant growth over the next several years. We are committed to optimizing your investments and capitalizing on opportunities in this ever-changing financial landscape.
Thank you for the trust you have placed in us to manage your hard-earned funds. If you have any questions or require further clarification, please do not hesitate to reach out. We are here to assist you in making informed decisions and guiding you towards a prosperous financial future.
Kessler Investment Group, LLC
All information in this presentation is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. All economic performance data is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. Certain statements contained within are forward looking statements including, but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Please consult your adviser for further information.
Opinions shared in this presentation are not intended to provide specific advice and should not be construed as recommendations for any individual. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk.