75 bps Hike, Looking Slightly Higher for Slightly Longer
This week, Federal Reserve (Fed) Chairman Jerome Powell announced the Fed’s decision to increase their key rate by 75 basis points (bps) or 0.75% to the target range of 3.00-3.25%, which was broadly anticipated by the market. The moral of the story for this meeting was the Fed’s adamant intention to return inflation to their 2% target rate (the August inflation print came in at 8.3% year-over-year, leaving the Fed far from that goal). Based on the summary of economic projections issued by the Fed (available here) they are looking for a peak Fed Funds target of 4.4% by the end of this year, and a 4.6% peak in 2023. This likely means another 75 bp hike at the October meeting, followed by 50 bp in December to conclude the year.
Future Rate Decisions
While the message certainly maintained the overtly hawkish stance we have witnessed since Powell’s address at the Fed’s Jackson Hole meeting, the Chairman claimed a few “successes” witnessed in the economy already: decreased consumer spending, lower fixed investment from businesses and corporations, and a cooling housing market. The Fed’s long-run Federal funds rate projection sits at 2.5% which indicates that they believe we have officially entered “restrictive” rate policy with this most recent hike to 3-3.25%. 2024 and 2025 rate targets sit at 3.9% and 2.9%, respectively, indicating the Fed intends to cut rates at the back half of 2023 and into 2024 and beyond to achieve their rate objectives. As repeatedly noted by Powell, this entirely depends on inflation and where it goes from here.
Largest Influences on the Fed’s Policy Decisions Going Forward
While inflation is clearly the Fed’s most important data point, there are a few key economic indicators which we believe are critical to note when projecting the Fed’s rate policy decisions.
1) Dollar Strength and International Weakness – perhaps most critical for the Fed to pay attention to is the strength of the U.S. dollar. The U.S. Dollar Index (DXY), a measure of the U.S. dollar relative to a basket of foreign currencies, is at a 20-year high and has appreciated by over 19% over the last year. Over the last year, key trading partners such as Great Britain, the EU, and Japan have seen the dollar appreciate by over 20%, 18%, and 31%, respectively.
A certain amount of dollar strength is good for the economy –imported goods are cheaper and purchases abroad are less expensive. However, it creates significant headwinds for U.S. corporations who export goods or conduct large parts of their business outside the country. International economies, particularly in Europe, face a bleak economic environment over the coming months, which is only propagated when dollar strength continues to advance. The growing divergence in interest rates between the U.S. Federal Reserve and international central banks will only continue to fuel DXY’s upward trajectory. In the coming months, the Fed will almost certainly see increased pressure from the European Central Bank and other central bankers to slow USD appreciation and reduce the impact of looming international recessions.
2) S. Government Debt Burden – International governing bodies aren’t the only ones likely to pressure the Fed into keeping rates lower. The U.S. government will face an enormous debt burden as rates increase and stay high. The Congressional Budget Office (CBO) projected in late May that the annual net interest costs would total $399 billion in 2022, and nearly triple over the upcoming decade. However, if the Fed continues to raise rates to levels higher than anticipated, this will only further increase the interest burden.
3) Year-Over-Year (YoY) Inflation Comparisons – This factor is less an economic data point and more a statistical reality moving forward – all future inflation increases will be compared to higher and higher inflation levels. Although it appears the inflation we’ve experienced is now entrenched, we will likely begin to see lower YoY figures as index levels are compared to the higher prints which start to tick up significantly in October. The August reading was compared to a 5.2% increase from the year prior, September will be similar at a 5.4% YoY increase in 2021, but October jumps to a comparison of 6.24%, November at 6.83%, and December at 7.1%. It is hopeful we will see inflation prints decrease notably at this point so the Fed can be satisfied with their hiking agenda.
Our Portfolio Positioning
This Fed decision does not change our conviction in the assets we hold in our portfolios. We believe this meeting reiterated what the market already believed to be true and had mostly priced in. Initial index price reaction was negative as the news hit the wire, but we don’t believe it changes our future expectations. We continue to stress the importance of sector allocation and security selection. The increase in dollar strength has confirmed our focus on U.S. companies that generate income internally. Cash flow generation and profitability are key in this tumultuous economic environment, and we are invested overwhelmingly in companies with stable earnings and strong prospects for growth. Energy remains our highest conviction sector as we believe the combination of domestic and European demand, U.S. Government policy, the reopening of the Chinese economy, and the continued conflict between Russia and Ukraine will support crude and natural gas markets. We continue to invest in resilient industries and companies that will benefit from inflation. For income generating accounts, we are heavily positioned in U.S. REITs, primarily in necessity-driven subsectors of multi-family, grocery-anchored shopping centers, industrial, and data center that will benefit from rent increases. Finally, we continue to invest in the preferred shares of major financial institutions that feature attractive yields at favorable risk levels. As we continue to see inflation prints and Fed meetings, volatility will persist, so it is critical to focus on investing for the long-term. The end of Fed hawkishness is almost in sight, at which point we expect a return to positive equity markets and a less-stressful investing environment.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
The US Dollar Index (USDX, DXY) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of US trade partners’ currencies.
The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.