How the Fed’s Balancing Act Could Play Out

The US Federal Reserve has rapidly raised interest rates over the past half year to rein in the highest inflation in a generation. And this week, it hiked rates by an outsized 75 basis points for a second straight meeting, and signalled that another large increase could be in store for its next meeting in September.

The Fed now faces a delicate balancing act as it attempts to fight inflation while supporting economic growth. The central bank’s ultimate aim is to achieve a “soft landing” – a state where inflation comes under control without the economy falling into recession. But the Fed’s rapid pace of interest rate hikes are making this soft landing increasingly hard to achieve.

All eyes are now on where the economy is heading. Will we achieve the soft landing, or will we end up in a recession or stagflation? This month, we’ll take a look at the state of the economy and how certain asset classes pave the way to an eventual recovery. We also look at why you shouldn’t sell out of your investments amid the ongoing market volatility.

Key takeaways:

• Latest signals from our investment framework, ERAA®, suggest that the US and global economies are edging closer to a stagflationary economic regime.
• Past downturns point to certain assets paving the way to an eventual recovery. Bonds and defensive equity sectors do better in a recessionary environment, while cyclical sectors outperform during the recovery phase.
• If you’re worried about further declines in the markets, it could be tempting to pull out your investments before they see more negative returns – but it’s almost impossible to time the market.
• If you’re a long-term investor, selling your investments now means you’ll have to worry about when to re-enter the market in the next few months. And there’s a good chance that you could miss the initial rebound, which could hugely affect your long-term returns.

First, here’s more about stagflation and recession

The economy moves through stages of growth and contraction in a cyclical pattern – this is what we call the economic cycle. Our investment framework, ERAA®, defines four stages of the economic cycle: good times, inflationary growth, stagflation, and recession. (Read more about ERAA® and the four economic regimes.)

• Stagflation occurs when inflation is left unchecked and eats into economic growth, driving the economy into a combination of stagnation and high inflation.
• Recession is marked by negative economic growth and low inflation – falling wages tend to follow this cycle, which in turn affects consumers’ spending abilities.

The latest signals from ERAA® suggest that the US and global economies are edging closer to a stagflationary economic regime (where inflation is high and growth is low).

But persistent inflation is putting pressure on central banks to hike interest rates aggressively, raising the risk of recession in the year ahead. That’s because rising interest rates make borrowing more expensive for consumers and businesses, helping to cool down the economy. For the US, economists now forecast a 40% probability of recession over the next 12 months.

What could the road to economic recovery look like?

Regardless of whether the economy moves into stagflation or recession – or manages to avoid a downturn altogether – the uncertainty will likely cause markets to remain volatile in the months ahead. As a long-term investor, it’s important to know that markets will eventually recover. But here’s what you can expect to see in the mid-term.

Looking at past downturns and recoveries, we see that asset classes perform differently as they move through the economic cycle. While the chart below outlines the recovery from the COVID-19 recession, we saw the same pattern unfold after the 2008 Global Financial Crisis and the 2018 market correction during the US-China trade war and Fed tightening.

Bonds tend to rise first as the market prices in a recession

History shows that bonds tend to outperform equities in a recessionary environment, as investors tend to shun riskier assets in favour of safe havens like US Treasuries. In addition, bond prices and interest rates have an inverse relationship. So, it’s expected that when the Fed cuts interest rates, bond prices will recover. You can see that relationship playing out in the chart above: US Treasury prices jumped as the Fed slashed rates at the start of the pandemic in early 2020.

In fact, the bond market is already pricing in the probability that the Fed will start reversing course and lowering interest rates next year. This signals that investors expect a recession is on the horizon.

Defensive equity sectors outperform during a recession, while cyclical sectors outperform in a recovery

During a recessionary environment, more defensive equity sectors such as consumer staples and healthcare do better, while cyclical sectors (those whose revenues are more sensitive to macroeconomic conditions – like industrials and information technology) lag. Once we move to the recovery phase, this trend usually reverses and cyclicals tend to outperform.

We saw this trend play out in 2020, with defensive stocks leading the recovery in equities, followed by cyclical sectors (though the unique nature of this downturn lifted the technology sector faster than in past cycles). The chart below shows a similar pattern after the economic downturn in 2008-09.

Markets will recover in the long term, but in the medium term, it helps to have a diversified portfolio to help manage the risk of sharp declines in any single asset class.

Should you wait for the market to “bottom out” to continue investing?

The short answer is: no.

Right now, the market is still struggling with how much further tightening is needed – as inflation data has continued to surprise to the upside. If you’re worried about further declines in the markets, it could be tempting to pull out your investments before they see more negative returns.

In theory, this could seem like a good idea – because if you reinvest later when asset prices are at their lowest, you could benefit the most when the market rebounds.

The catch? Markets are unpredictable, and timing the market is almost impossible. Even if you follow the news, headlines are typically still very negative at market bottoms, and rebounds often happen swiftly before the media can even report on them.

The chart above shows what just one month out of the market could cost you. Investor A held their investment through the COVID-19 market crash and subsequent rebound, while investor B panic-sold at the market bottom, held cash, and re-entered the market a month later.

While both investors started off with the same portfolio size, investor A would have broken even by the end of August, while investor B’s portfolio would still be down 15% from the start of the year.

Focus on the long term and diversify your exposure in volatile markets 

While the markets will eventually recover, we expect the Fed’s rate hikes to spark more volatility in the coming months. But if you’re a long-term investor, selling your investments now means you’ll have to worry about when to re-enter the market in the next few months. And there’s a good chance that you’ll miss the initial rebound, which could hugely affect your long-term returns.

We’ve seen that asset classes perform differently at each stage of the economic cycle, and that it’s difficult to predict when a rebound can happen. Because of this, maintaining a diversified portfolio is often the best way to weather periods of market volatility. Spreading out your investments across various asset classes helps to smooth out your returns over the long run, protecting your portfolio from the risk of large declines in any single asset.