Putting the Pullback into Perspective: A Look at Recent Market Volatility

The markets have been reacting negatively in response to the Federal Reserve’s hawkish meeting this week. During that meeting, there was a unanimous vote to increase the Federal Funds rate (FFR) by 75 basis points. As a result, the FFR now stands at 3% to 3.25.

So, what is the Fed trying to do? The Fed has a dual mandate: to keep unemployment low and prices stable. Unemployment is at 3.7%, so they have been successful on this metric. However, inflation is too high, as evidenced by the August Consumer Price Index (CPI) metric of an 8.3% year-over-year increase. As such, the Fed is working to slow down the pace of price increases.

Prices are influenced by supply and demand. Central banks like the Fed have very little influence over supply, so they attempt to control prices by influencing demand. By raising rates, the Fed is looking to slow the economy (demand) to bring prices down. Many other rates in the economy are influenced by the FFR, such as mortgages, commercial loans, and car loans. Increased interest rates make these purchases more expensive and thus slow down demand.

However, the market is concerned that the Fed’s actions and hawkish tone will slow the economy by too much and trigger a recession. The forward guidance highlighted by the Fed’s “dot plot” indicates a likely terminal FFR of 4.6% in 2023; this was more aggressive than market expectations and led to a subsequent steep rise in short-term and longer-term interest rates. The increasingly widespread belief that the Fed is overshooting—without appreciating the lagged effects of its rate hikes or anecdotal evidence of slowing inflation—has been a major contributor to the downward pressure on global stock markets during the latter part of this week. In addition, the technical aspects of the market have weakened, which increases the prospect of short-term downward pressure and higher volatility.

As we continue to assess the forward-looking risk/return outlook for various asset classes, it is important to remember that over longer periods of time, market fundamentals ultimately drive market performance. Here are a few positive data points that investors should also keep in mind, as these may not be emphasized in the financial media:

• ​Earnings growth for U.S. equities (S&P 500) is still projected to be positive in 2022 and 2023.
• ​With unemployment so low, the Fed can afford to be vigilant in fighting inflation. If both inflation and unemployment were high, the Fed’s job would be more difficult.
• ​Higher interest rates are also creating higher yields for savers and fixed income investors, which in turn will generate greater cash flow and higher expected returns moving forward.
• ​2023 will be the third year in the presidential cycle, which historically has been favorable for the markets. Seasonality will typically also become more positive as we exit September.
• ​Peak inflation appears to be behind us. Although the decline may not be as quick or as steady as many would hope for, the downward trajectory for the CPI is promising. Additionally, many commodities and key components within the price index have been experiencing price declines. Thus, the Fed appears to be having some initial success in bringing down prices.
• ​In many ways, the US economy is going through its typical business cycle, which we have experienced many times in the past. Although each business cycle is different, the general framework is familiar, and navigating the challenging environment requires time and patience.

FederalReserve.gov

Bureau of Labor Statistics

FactSet