The eye of a hurricane is a deceptively dangerous place. Those lucky enough to make it in unscathed can enjoy a well-deserved respite, but blue skies and calm winds also create a false sense of security and encourage complacency. Some people may even be convinced that the storm has passed. The truth, however, is that the eye only offers a brief intermission, and the worst is yet to come.
The US Federal Reserve raised the federal funds rate by 75 basis points on July 27, 2022. Many investors had feared a more aggressive 100 basis point hike, so the relief was palpable. The next day, the Bureau of Economic Analysis (BEA) released its advance estimate of GDP growth for the second quarter. The negative second-quarter reading of 0.9% followed a 1.6% decline in the first quarter and sparked unnecessary debate about whether the US economy was in recession.
The combination of a less-than-worried interest rate hike and two consecutive quarters of negative economic growth led to a sharp rally in US stocks and other risk assets. Implicit in this recovery was the hope that the Fed would soon ease its monetary tightening and that the much-feared recession was already in the rearview mirror.
12-Month Tracking of US Inflation and Cumulative Federal Rate Increases: Post WWI/Flu and Post-COVID-19
Indeed, as July gave way to August, a surprisingly strong jobs report and lower-than-expected CPI numbers made investors even more optimistic. You can hardly be blamed for enjoying the sunny skies and losing sight of the second hurricane wall potentially looming on the horizon. While this optimism may be tempting, it is inconsistent with the lessons of financial history, particularly the US experience in the years after World War I and the years before the Great Inflation.
The Fed is now fighting inflation, not a recession, and it’s too early to declare victory. The biggest mistake in the Fed’s history was letting inflation fester for too long in the late 1960s. The Fed’s mistakes allowed inflation expectations to become entrenched, and the US economy paid a heavy price in the form of more than a decade of stagnation. The Fed under Jerome Powell is unlikely to repeat that mistake, and taming inflation decisively will likely require more pain.
Watch out for the Ides of October
So when will the second wall of the monetary hurricane hit? It’s impossible to say. The Fed may even defy the odds and orchestrate a soft landing. But if the storm comes, look out for the Ides of October 2022. Not only will the Fed’s tightening cycle be in its final stages, but October is a notorious month for financial panics. The agricultural finance cycle of the 19th century first gave rise to periodic October panics, but even after the United States made the transition to an industrial and consumer economy, the instinctive fear of October produced the occasional self-fulfilling prophecy.
Financial history suggests more market volatility and economic pain before the Fed wins its battle against inflation. This does not mean, however, that investors should adopt tactical asset allocation, that would be speculation rather than investment. Rather, they simply need to maintain their situational awareness, stay committed to their long-term asset allocation goals, rebalance as appropriate, and continue to steel their nerves for further volatility and downturns. prices.
If you liked this post, don’t forget to subscribe to Entrepreneurial investor.
All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images/Stocktrek Images
Professional training for CFA Institute members
CFA Institute members have the power to self-determine and self-report professional learning (PL) credits earned, including content on Entrepreneurial investor. Members can easily register credits using their online PL tracker.
Mark J. Higgins, CFA, CFP
