Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
The Federal Reserve on Wednesday announced a 75-basis-point increase in its key interest rate as it continues battling inflation. Markets had largely already priced in the move after recent consumer price readings came in hotter than expected and surveys pointed to consumer expectations of inflation rising.
The latest Consumer Price Index figures from the Bureau of Labor Statistics showed inflation up 8.6 percent year over year, with notable price surges in food and gas — up 10.1 percent and 49 percent year over year, respectively. While core CPI (which excludes food and energy) continued to drop, it was still higher than expected. Couple this with the University of Michigan Consumer Sentiment Index showing expectations for inflation 5 to 10 years into the future now stand at 3.3 percent, which is a new high for this cycle, and with the exception of a brief two-month blip in 2008, the highest it has been since 1996.
The uptick in expectations is troubling and likely contributed to the Federal Reserve Board’s decision to raise the rate by 75 basis points instead of the 50 basis points it telegraphed just last month. Inflation expectations are key, and Fed Chairman Jerome Powell wants to make sure that expectations for future inflation remain anchored instead of drifting higher. And while core inflation readings have cooled somewhat since the Fed began tightening, the pace has been too slow to prevent expectations creeping up.
Recent inflation data has raised the possibility that the Fed may have to maintain a more aggressive stance toward rates for the remainder of the summer. However, we’ve already seen improvements in the supply/demand imbalance that has been fueling inflation. In the most recent CPI data, core inflation, which strips out volatile energy and food prices, came in at 6 percent year over year, versus expectations of 5.9 percent, but down from April’s reading of 6.2 percent. The New York Federal Supply Chain Index has eased from a reading of 4.4 at the beginning of the year to 2.9 in May. Additionally, recent data from the Institute of Supply Management similarly show the backlogs are easing and supplier delivery times are improving, which should lead to further reduction in manufacturing constraints. Rising interest rates have led to a drop in home buying activity and price softening in some areas. Finally, major retailers such as Target and Walmart have noted growing inventories that they plan to clear through price discounts, part of reining in inflation.
What to look for moving forward
Given that markets are already positioned for additional increases, what matters most now is the pace of tightening financial conditions and how that may impact the need for future rate hikes (which are already priced into markets). As we wrote in a recent weekly market commentary, financial conditions continue to tighten, according to the latest National Financial Conditions Index from the Federal Reserve Bank of Chicago. The current reading builds on a trend of steep tightening that began in October 2021. Powell has noted that financial conditions are what the Fed is broadly targeting when it implements rate hikes.
With the latest rate hike and additional hikes that could be as high as 75 basis points already broadly anticipated and Powell indicating additional hikes of 50-75 basis points on the table in the coming months, we expect conditions will ratchet down further. And while the loudest voices in the financial press seem to be shouting about inflation in unison, it’s important to note that there was some disagreement among those who actually control rates, with Fed Governor Esther George dissenting in favor of a more modest 50-basis-point hike. The lack of unanimity among the voting members underscores the point that the Fed is nimble, and the final path of this hiking cycle is not a foregone conclusion. As a result, we expect more volatility will come but do not believe investors should make significant adjustments to their portfolios.
We believe that the supply disruption and demand imbalances that have resulted from COVID’s arrival are alleviating now as the economy shifts toward a pre-COVID “normal.” Couple this “natural alleviation” of inflation and the resulting demand destruction that will occur because of the tightening of financial conditions, and we believe that inflation is set to moderate. The question is, how fast? Recent data led the Fed to determine that prices were not easing fast enough. Tightening further allows them to keep expectations anchored.
Tighter conditions and slowing demand should hasten the deceleration of inflation and could provide the Fed with room to undershoot rate hike expectations later in the cycle. If that were to occur, we could see a jump in market volatility — but to the upside.
Times like this can be difficult for investors. The S&P 500 recently crossed into bear market territory, and many of the more speculative stocks we categorize as “hopes, dreams, memes and themes” have seen their values cut in half. However, some of the downward pressure on equities is simply a product of excessive speculation unwinding and a selling mentality seeping into the broader market.
While no one can predict when the market will regain its footing, we believe much of the repricing for slower economic growth has already taken place. The level of pessimism that investors have shown of late as reflected in the American Association of Individual Investor’s (AAII) Investor Sentiment Survey as well as spikes in the Chicago Board Options Exchange so-called fear index could amplify positive moves in equities should inflation readings come in lower than anticipated in the future. Furthermore, while we don’t know when markets will bottom, they will eventually bottom and likely move higher over time as they have throughout history. And while a recession could occur at some point in the future, we continue to believe it would be mild given the overall state of the U.S. consumer and corporations. The current backdrop reminds us more of the 2000-02 environment than the Great Financial Crisis of 2007-2009. Although there was a recession in 2002, it was mild, and speculative areas of the market took the brunt of the pain. However, many parts of the market did well during the period, including active management.
If you’re concerned about how rising rates, inflation or a recession could impact your financial plan, you should have a conversation with your advisor. The fact is wealth isn’t generated only when times are good but also by the decisions you make when the markets are under pressure. When others feel the need to react and grasp for short-term gains from one day to the next, we’re able to tune out the noise. Our ability to remain steadfast and use it as an opportunity for growth, helping capture the upside when the markets eventually recover, comes from our longstanding commitment to drive value over time. Because we’ve seen that playing the long game tends to win, generation after generation.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.