News about the economy and financial markets is everywhere these days, with good reason. Inflation has been running hot since last year, and the Fed’s aggressive moves to bring it back down have not yet yielded the results we are all expecting. Put simply, the Fed raises interest rates, which then increases the cost of borrowing money. The hope is that consumers will respond to higher prices and higher borrowing costs by not spending as much, thereby forcing prices down.
This tactic is not yet showing positive results, as American consumers are still spending at a pretty good clip, which keeps headline inflation fairly steady and rattles financial markets. Impatience may be getting the better of us, considering that a normal time horizon to really start to correct inflation is 12-18 months. If that timeframe is correct, we may still have choppy waters over the next 6-9 months but could see some solid improvement by mid-2023. Read on for our ideas about how you can stay on course until the recovery process begins.
How We Got Here
The Fed missed the severity of the inflation surge through the end of last year. They had assessed that it was “transitory” and would essentially self-correct as the effects of COVID subsided. In short, they expected consumer demand to wane and for the supply chain to ease, neither of which happened. The messaging from the Fed coming into 2022 was that they would start to raise rates gradually, essentially to return to a more “normal” interest rate policy where we were before the pandemic, with a focus on making sure inflation was in check with their long-term target of 2%.
As it became clear that inflation was becoming more entrenched, Fed Chair Jerome Powell announced in March that the Fed would become very aggressive about raising interest rates to bring prices back down. Financial markets don’t like surprises, and both the stock and the bond markets sold off quickly through the second quarter. After the stock market hit a low on June 16th, it began a fairly impressive rebound through July and August.
Where We Are Now
The summer market rally was premature, as conditions had not yet improved. At the Fed’s annual August meeting in Jackson Hole, Fed Chair Jerome Powell reinforced the Fed's stance that its current goal is to reduce inflation. The August inflation number, reported in September, was higher than most economists - and certainly all of Wall Street - wanted to see. On the heels of that data, the Fed announced an interest rate increase of 0.75%.
This rate increase was completely in line with previous expectations. However, there were details in Powell’s speech that were materially new, as he made clear that the Fed’s current singular goal is to fight inflation: “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.” He also acknowledged that this journey may cause pain to Americans in a variety of ways: higher unemployment, higher prices until they can control it, and higher borrowing costs. The Fed now expects to end the year with rates at 4.25-4.5%, a full percentage point higher than they announced as recently as June. That is a substantial change and shows their commitment to decreasing inflation to their long-term target of 2%.
While September brought the US stock market all the way back down to its June lows, October has again staged an impressive rebound due to both some positive surprises during earnings season and an expectation that the Fed will slow its interest rate increases in the near future. While third-quarter GDP was also positive, the outlook for early 2023 is quite murky, with many business analysts, economists, and market watchers anticipating a recession, especially if the Fed continues to raise rates into the new year.
Steps You Can Take for the Future
Every crisis eventually fades, but there are steps you can take now and consider for the not-too-distant future as we move into recovery. Below are some of the ways we are working with our clients through this challenging time.
1. Know your financial plan.
In times of uncertainty, it’s important to keep your longer-term goals clearly in sight to help you make decisions about today. For example, if you work in an industry that seems likely to have lay-offs in a potential recession but you have a goal to advance your career and continuously invest, you still have options. You could reduce your spending now, brush off your resume, and start researching other opportunities to have as a backup plan.
2. Check your cash.
Cash may not provide great performance returns, but its liquidity and stability provide options and flexibility. We start every financial plan with an understanding of the cash needed for a person or family to weather unexpected events. Figure out how long your cash can support you through rising prices or other uncertainty, and then assess whether you need to increase this level. Also, if you need to take a withdrawal from your portfolio in the next few months, be strategic in determining which funds to use. Performance across asset classes has varied widely, and there are ways to limit the downside.
3. Review your allocation.
As you know, past performance is no indication of future results, and that is especially true now. The near-zero interest rate environment was very beneficial for growth stocks for the last 10+ years, so many portfolios are overweight growth. However, that landscape is behind us for now. With interest rates expected to settle in the 3-4% range in the mid-term, value and dividend-producing stocks are likely to be in favor going forward. The outlook for international stocks is also quite debatable, with increased challenges in China, Europe, and the UK, while Japan is having a unique moment as a benefactor of today’s environment.
4. Look for opportunities.
Even challenging markets present opportunities with your portfolio, especially when it comes to taxes. Two ideas to consider are converting Traditional IRA dollars to Roth IRA dollars while the value is down, and harvesting tax losses in your non-retirement funds. Your tax advisor can help you with loss harvesting if you don’t already have a financial advisor who is analyzing it for you.
5. Consider your risk tolerance
Downturns are part of the normal movement of the financial markets. If markets went up all of the time, everyone would invest in assets with the highest performance. However, high performance normally comes with high risk, which includes the possibility of a temporary loss. We don’t recommend changing your risk level in the midst of volatility, but it’s a good time for a gut check about how much risk you want to have in your investments.
Take our Risk Tolerance quiz here: https://app.precisefp.com/w/n131xa
We know this is a challenging time to be an investor, and we will keep bringing you updates so you can make informed, confident decisions about your money. Soon we will release Risks and Opportunities, our quarterly market report, which will be a deep dive into where we are and where we expect to go. If you have questions about your financial plan or portfolio, contact us at email@example.com.
Debra Brennan Tagg is a CERTIFIED FINANCIAL PLANNER™ Professional and the creator of the DBT360 Financial Plan, a proprietary program that helps her clients prioritize their goals, leverage their resources, and address their risks. She is the president of BFS Advisory Group and teaches the public and the financial services industry about the importance of values-based financial planning and investor education.