Why are markets so volatile even though the Federal Reserve telegraphed their interest rate stance?
Under the leadership of Chairman Jerome Powell, today’s Federal Reserve Board was supposed to be different than boards of the past. Although the Fed’s dual mandate continues to be maximum sustainable employment and stable prices, a goal of this board was to be more transparent about their thinking and potential Fed Funds interest rate shifts. The Fed hoped that improved transparency would reduce market volatility when it changed interest rate policy from easing (lowering) to tightening (raising) short-term interest rates and vice-versa. But why have markets been so volatile as the Fed has been more transparent? A fifteen-year period of major market shocks are mainly to blame.
The fifteen-year stretch began with the global financial crisis of 2007-2009. In response to the unprecedented credit and asset price bubble, the Fed was forced to reduce short-term interest rates from over 5% in 2007 to essentially 0% by the end of 2008. Although lower interest rates initially helped the economy to regain footing and grow, several subsequent shocks forced interest rates to stay at record levels, even though the Fed desired higher, more normalized rates. As shown in the chart below the Fed Funds were dropped from over 5% in 2007 toward 0% by the end of 2008.
The European sovereign debt crisis was the next shock. As the U.S. economy bottomed and began recovering, Europe experienced a debt crisis which peaked in 2011, when interest rate spreads, or the extra yield investors demand to hold bonds from lower credit quality countries like Greece vs a higher credit quality country like Germany, widened dramatically. At the time, many market participants feared a potential European sovereign default that would drag the global economy back into a recession.
Then in 2015, global recession fears appeared once again, leading the Fed to continue to anchor rates near 0%. Recession fears sent oil plummeting from over $110 per barrel to the mid-$30s, Greece required a third debt bailout, and Chinese stock market volatility spiked.
Finally, the Fed started to raise rates at the end of 2015, seven years after lowering them to 0% and likely much later than the Fed ever expected. Despite a U.S./China trade war, and continued economic uncertainty, the Fed continued to raise rates until they peaked in early 2019. However, by early 2020, the first global pandemic in a century struck, and the Fed was forced to accelerate the easing cycle it had started in the summer of 2019, pushing the Fed Funds back to 0%.
Now that the pandemic has started to recede, the Fed has once again started to raise short-term interest rates. This policy change has caused market volatility to spike for three major reasons. First, a prolonged period of 0% short-term interest rates and record low borrowing costs caused a gradual increase in speculation (think SPACs, meme stocks, crypto, NFTs). Additionally, growth stocks, which generally derive their value from expected profits far in the future, saw their valuations rise higher and higher as discount rates fell to record lows. The market’s perception of the difference between the value of a dollar today and a dollar ten years, or more, in the future narrowed to record lows, thus improving the valuations and prices of growth stocks – even unprofitable ones. In the following chart you can see the gradual and consistent increase in the valuation of the Nasdaq 100, a main growth stock index. From mid-2011 to late-2020, the forward P/E rose from 11x to 32x. This is versus a multi-decade average of 22x.
When the Fed signaled its intent to change its 0% interest rate policy in late 2021, the speculative bubbles began popping, and growth valuations began deflating. The declines were brutal for investors who were overallocated to these areas. Below is a one-year chart showing the returns of these speculative investment groups, many of which will never have earnings or even revenue. It is interesting to note the best performer of these groups was actually Bitcoin which only fell 23% over the past year. IPOs, cannabis, “innovation” mutual funds, and other crypto products fell 40% or more over the past year.
The second reason for the volatility spike has been due to surging inflation. The onset of the pandemic caused demand to temporarily drop, supply dropped as well, along with the efficiency of the supply chain. Once demand returned, inventories were extremely low, and the ability to create a future supply of goods was hindered through shuttered manufacturing and a temporarily broken supply chain. The consumer price index (CPI) has risen to a multi-decade high, along with the commodity index, as shown below in a one-year chart – up nearly 50%.
Today as the Fed begins to aggressively hike interest rates, market participants worry we may endure a period of high inflation alongside weakening economic growth – otherwise known as stagflation (akin to what we experienced in the 1970’s). Since the 10-year U.S. Treasury rate can be viewed as a barometer for the level and direction of consumer loan rates for homes and autos, the recent increase from under 1.20% to 2.50% during the past year (below) adds to the recession fears.
The fixed income asset class posted a negative return of approximately 4% for the first quarter. If this negative 4% return holds for the entire year of 2022, the year would go down as the worst in at least four decades for fixed income.
Third, once the Russia-Ukraine war began, markets finally succumbed to the pressure of rising interest rates, increasing inflation, and escalating geopolitical risk. At the recent market lows, the average U.S. stock had fallen 34% from its recent highs. The volatility index (VIX) doubled in a few short months during this time to levels last seen at the peak fear levels of the pandemic.
So how does our investment team think through this period of outsized volatility? The main key to investing is to use a strong approach and discipline, reduce the influence of emotion, and to always remember markets are priced on expectations for the future. For example, the consensus today seems to feel growth stocks, fixed income, and consumer discretionary equities are to be avoided because “interest rates are rising and the economy may head into a recession”. However, we believe markets have priced in much of these fears. Although some growth stocks continue to be overvalued, others sport valuations near their pandemic lows. The following two-year valuation chart of the S&P software index, shows enterprise value-to-revenue valuations that nearly touched 6x, within one point of the pandemic low, after peaking last summer at nearly 11x.
Additionally, a number of consumer-related stocks are now very inexpensive with solid reward-to-risk ratios, and strong multi-year fundamental outlooks. The S&P homebuilders index is now trading below the long-term price-to-book value and tangible book value averages, while intermediate-term demand tailwinds appear intact. Overall, while defensive sectors such as utilities and consumer staples are now trading at near record high valuations (see the utilities 20-year P/E chart below), more compelling values can be found elsewhere, away from the consensus view.
Finally, while many market participants view volatility as a negative, we believe it is an opportunity. If you employ a strict, time-tested discipline that seeks to reduce emotional investing, and to add high reward-to-risk investments to the portfolio, volatility can equal opportunity. Volatility provides the opportunity to purchase investments with strong fundamentals at discounted valuations. Please see Jay Skaalen’s piece for expanded thoughts on our views of volatility when managing your portfolio.