Elean
Hi everyone. Welcome to the podcast and thank you for tuning in. I’m Elean Mendoza and I’m here with Evan Shorten, the firm’s founder and principal.

Evan
Hello this is Evan. I hope you’re all doing well and I want to thank you for listening. Today we’re going to be doing a market update building on last weekend’s client email. In it we briefly discussed markets, interest rates, and the current challenges the Fed faces with monetary policy. But before we get started, if you want to stay up-to-date with our announcements and email communications, please sign up to our emailing list by visiting paragonfinancialpartners.com and entering your information right on the homepage where it says “Sign Up for Our Latest Insights.” Additionally, you can subscribe to the podcast on the Apple Podcasts App, Stitcher Radio, or to our YouTube channel if you haven’t done so already.

So with that, let’s get started.

Elean
The state of the economy is currently in a spot we have not seen in decades where the economy is slowing down, many would even say we’re in a recession, while simultaneously experiencing decade’s high levels of inflation. One big reason for why we’re here are the lingering effects of the Covid Pandemic which devastated supply chains and economic production, all while governments around the world injected record levels of money into the world economy. In the U.S. it’s estimated that about $10 trillion new dollars were added to the economy through various emergency programs and industry bailouts. Additionally, war between Ukraine and Russia has exacerbated the lack of available commodities and resources around the world causing production slowdowns and food shortages globally. All this has put central bankers, whose job it is to maintain price stability, in a tight spot and equity markets have taken notice.

Now that’s the very high level view of where things stand today. Evan can you go into more detail.

Evan
As we wrote in our most recent email. Jerome Powell and the Federal Reserve are really stuck between a rock and a hard place. We’re now in our second year of increasingly high inflation with the August 2022 Consumer Price Index posting an 8.3% inflation rate on top of a 5.3% inflation rate from the prior year August 2021. Whether it’s because of money printing since the 2008 Global Financial Crisis, the 2020 Pandemic and the $10 trillion response, or external forces like Ukraine and Russia; at some point inflation catches up to all the money printing.

Now, on one hand, the Federal Reserve needs to slow inflation in order to fulfill one of its primary mandates – price stability. On the other hand, the economy has slowed down significantly posting two quarters in a row with negative GDP and estimates that Q3 may experience near zero GDP growth at best. The issue here is, the primary tool the Federal Reserve has to fight inflation, known as quantitative tightening, can also cripple a slowing economy. Essentially, Jerome Powell has to walk a fine line between trying to raise rates to fight inflation without hurting the economy too much.

Elean
And for a while Powell did claim the Federal Reserve could engineer a soft landing, but that notion has all but disappeared and has been replaced with Powell’s recent language of “there will be some pain,” which he first stated in his Jackson Hole Wyoming speech and reiterated this past Wednesday during the interest rate press conference.

Evan
Right. Powell has gone all in on raising rates until inflation can be tamed even if it means a recession and pain for the economy. To date, the Federal Reserve has raised rates five times with the most recent three hikes being .75% each bringing the Federal Reserve’s Funds Rate to about 3%/3.25% from near 0% just this past February 2022.

Elean
Now the interesting thing is that equity markets have been all over the place this year despite Powell being fairly transparent about raising rates all the way into 2023. We saw the S&P500 make all-time highs in early January 2022; it fell to a then yearly low in June 2022; then staged a summer recovery; and as of Friday, September 23, fell to a new yearly low. There were even times earlier this year when equity markets almost seemed to disregard Powell’s commitment to raise rates.

Evan
That tells us the market’s don’t know what to believe. Is Powell going to stay the course and fight inflation all the way or will there be a Powell pivot to protect the markets from any significant pain? Essentially, Powell and the Federal Reserve have a credibility problem that stems from decades of Federal Reserve bailouts.

Elean
So let’s go into that a little bit more. It might be hard for some people to believe that our financial markets don’t take the Chairman of the Federal Reserve too seriously given he holds one of the most important positions in arguably the entire world. At the end of the day, Jerome Powell controls the US dollar which is the World Reserve Currency. However, despite his position, there have been days when markets dismiss his resolve to fight inflation.

Evan
So the Federal Reserve has backstopped Wall Street since the Greenspan days.
-In 1998 Alan Greenspan and the Federal Reserve bailed out Long-Term Capital Management. A Hedge fund that had taken on so much leverage it risked collapsing the financial markets. This marked the first time, the Federal Reserve stepped in to save Wall Street.

-In 2008 during the Global Financial Crisis Ben Bernanke and the Federal Reserve bailed out the entire financial system. Not only was this the biggest bailout ever conducted up to this point, but they also went as far as providing bailout funds to Canadian banks as well.

-Starting in 2015 Janet Yellen began the process of quantitative tightening, albeit at a very, very, very slow pace. However, once Jerome Powell became the head of the Federal Reserve in 2018, he ceased quantitative tightening and pivoted back to dropping interest rates – this is where the term “Powell Pivot” originates from.

-In 2020 in response to the pandemic, Powell bails out the stock market by taking on the debt of private corporations and providing the liquidity to bailout corporations across all sectors in the economy.

-In March of 2020 Neel Kashkari, the President of the Federal Reserve Bank of Minneapolis, says the quite part out loud in a 60 Minutes interview, “there is an infinite supply of cash,” when responding to how much aid the Federal Reserve could provide in response to the Covid-19 pandemic.

-Lastly, let’s not forget the biggest black eye on the Federal Reserve’s credibility. With inflation rapidly on the rise in 2021, Jerome Powell continued the policy of quantitative easing, aka money printing, claiming inflation was merely “transitory.” – A statement he would then have to retract within a few months.

So here we are in 2022 and equity markets were not taking Jerome Powell too seriously during the first four rate hikes. One of the most common questions we have heard this year in both talking to clients and talking to other firms is “when will Powell pivot?” Up until Powell’s Jackson Hole, Wyoming speech, it seems like markets were operating under the assumption that a pivot was a matter of “when” as opposed to “if” it would occur.

Elean
In other words, Powell isn’t just stuck between a rock and a hard place, he’s stuck between a rock, a hard place, and with his back against a wall known as credibility.

Evan
Right. And with the market’s reaction from Wednesday’s rate hike and corresponding press conference, it seems the markets finally took Powell seriously, but only time will tell. The bigger issue I personally see is Powell trying to restore the Federal Reserve’s credibility in addition to fighting inflation.

Elean
What do you mean that?

Evan
Well Powell already has the near impossible task of taming inflation while not destroying the economy. He’s been pretty adamant that there could be a small recession as a result, but he’s willing to accept that. If asset prices move up again like they did during the summer, the Fed is going to take that as a sign it needs to keep raising rates at a fast pace ultimately exacerbating the chance of destroying the economy. There is a risk that if markets at any point question Powell’s commitment to fighting inflation, he’ll have to overdo it with the rate hikes.

However, for now it seems that markets are getting message.

Elean
Ok, with that said, what’s your opinion on markets at the moment?

Evan
Approach with caution. I don’t mean that in an ominous way or anything like that, but equity markets are probably going to be reactive to whatever Jerome Powell says or does. As long as they’re increasing rates, I don’t see too much market upside in the coming months. Equity markets could be mutated or trade in a sideways range though much of 2023. That said, I wouldn’t abandon equities by any means. The economy and the financial markets all move in cycles and there will opportunities to buy great companies and stalwarts of industries, during market overreactions.

Two years ago, energy stocks were presumed dead. Up until 2022 fixed income was considered non-existent and now here we are and everything has changed.

Elean
Now there is a silver lining and we’ve talked about this in the office a number of times, and that’s fixed income.

Evan
Right. We mentioned this in our email as well. Up until this point, loose monetary policy has been damaging for savers and has made life difficult for retirees who need income from their portfolios over appreciation. Tight monetary policy has the complete opposite effect. It rewards savers and those looking for income.

One year ago, trying to find risk free income was impossible – it didn’t exist. As of Friday, September 23, the 1-year, 2-year, and 3-year treasury are all paying over 4% and the 5-year treasury is right under at about 3.97%. For those who can accept a little more risk for a higher yield, the US Corporate Bloomberg Fixed Income Index is posting a 5.38% average yield for corporate debt in the US. Retirees and risk adverse investors now have options to generate income from their portfolios. As rates increase more, there will be more income generating potential for investor’s portfolios.

Elean
Ok sounds good. We covered a lot in this episode and no doubt went a bit longer than usual so we’ll wrap things up quick. If you have any questions about what we discussed or would like someone to review your portfolio or current asset allocation, please don’t hesitate to give us a call. In the meantime, please subscribe to the podcast and to our email list. We’ll see you here next time.