Interest Rate Outlook
My observation is that the valuations of Corporate America as measured by the S&P 500 have yet to fully digest the impact of rising interest rates.
Since WWII the key drivers of inflation are energy (20%), labor costs (20%), government spending and Personal Consumption Expenditures (PCE) (60%). (Source: JP Morgan Guide to the Markets 12/31/2021)
Per the Bureau of Labor Statistics (BLS), energy costs were up 29.30% year over year (YoY).
Per Wisdom Tree Investments, Inc., labor costs were up +5.7% year over year (YoY).
Government spending is up slightly but PCE is up a strong +4.90%.
With the very HOT Consumer Price Index (CPI) report, which measures inflation at the household level, released 2/10/2022 up +7.50%, the U.S. Federal Reserve will now have the data needed to plan how much they will increase interest rates to slow inflation.
The markets have now priced in four rate hikes of ¼% each for an increase of 1% in 2022. To get ahead of “The Real Return Illusion™”, I wrote about in The Weekly Update on 1/14/2022 (read it here) I think the Fed will increase interest rates at least 2% in 2022.
But that’s not all! The Fed has been buying government bonds and mortgage securities to keep interest rates low. They now have nearly $10 trillion of same on their balance sheet. This is the highest in history and far from normal!
Per the Federal Reserve, reducing their balance sheet by just $1 trillion has the same effect as increasing interest rates 1%.
Expect the Fed Chair Jerome Powell to outline their interest rate increase plan after the next Fed meeting on March 15 – 16. My guess is a $3-5 trillion Fed balance sheet reduction, i.e., an interest rate increase equivalent of +3 - 5% in tandem with a 2%+ increase in the Fed Funds rate.
If close, this is an increase in interest rates of between 5-7% versus the market’s already priced in +1%.
The rising interest rates result in the discounting of future cashflows, especially for tech stocks, which could result in some potential downward pressure in prices.
The good news is no one knows the future. I could be wrong, but if I am off, it is only by a few percentage points and still significantly above what investors now have priced into the current valuations.
We are investing cautiously here, as markets don’t like surprises, and to me this level of inflation and the resulting increase in interest rates to offset “The Real Return Illusion” could be an unpleasant surprise.
You will also be happy to know that our WSG client asset allocations and investment positions are now being aligned for this type of surprise party.
If there is someone in your work, social circle or family that would be interested in a “second opinion” around their investment allocation and strategy, feel welcome to share our contact information.
As always, our team and I are available to discuss this concept with you. Just call, email or stop by the office and say “Hi”!
Respectfully,
James O. Lunney, CFP®
CERTIFIED FINANCIAL PLANNER™ Professional
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Investing involves risk. Loss, including loss of principal, may occur. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.