The main focal point of 2022, so far, has been the efforts of the United States Federal Reserve to fight inflation through monetary policy. The decisions to raise rates year-to-date have been nearly unprecedented in magnitude, representing the fastest climb in the policy rate in the last 4 decades.
With the first six Federal Reserve meetings of the year behind us, many investors have turned their focus to the upcoming meeting on November 1-2. In preparation for this meeting, investors should recognize that markets operate as information processing machines, constantly incorporating information about future expectations into current prices. Furthermore, they should understand that the forces that move markets are unexpected news, not expected news, and that even events that are objectively bad for markets can result in positive returns to the extent that they were unexpected.
Here’s a useful example:
Suppose you were selling your house. You know that there are some old pipes in the basement that are likely rusted, and the air conditioning system likely also needs to be replaced. However, you are in a rush to sell your house, so you put it on the market at a price that reflects those expectations. A few months later you finally get a chance to go look around, and you notice that the pipes aren’t rusted as badly as you had thought; only 50% of the pipes need to be replaced and the A/C does not need to be replaced at all! How would you change the asking price for your house?
This is a useful example because it gets at the heart of the importance of information relative to expectations and forces you to think about how you would respond to new information. Objectively, having to replace pipes in your house is bad, as it will be expensive. But upon finding out only half of the pipes need to be replaced when your original expectation was all of them would need replacement is actually relatively good. Markets function in the same way.
While investors look at many economic measures to gauge the health of the economy, the primary focus of the Fed this year seems to be on inflation. There are several recent indicators suggesting that inflation may be moderating:
- As reported by Redfin, median national asking rent declined in September indicating slowing rental price inflation
- The price of gold, generally regarded as a leading indicator for inflation, has been steadily declining
- Futures prices are estimating cheaper oil prices in the future; energy prices have been a large contributor to inflation year-to-date
- The OECD Consumer Confidence Index, having fallen in six straight months to start the year, has held steady for three straight months
- CAPE/Schiller Home Prices index seems to have peaked in June, suggesting a slowdown in housing price inflation
Many derivative markets exist specifically for investors to place bets on various financial instruments, using information in these indicators to predict future prices; for example, investors can trade futures contracts on the Fed funds rate. Prices of these derivatives react, nearly instantly, to new information. You can see this behavior in practice on October 13th, where the future rate hike expectation passed 75bps for the first time on the back of a worse-than-expected CPI data release.
As of 10/21, the market is expecting a 77 bps increase in the Fed funds rate coming out of the November meeting. This translates roughly to a 93% chance of a 75 bps increase and a roughly 7% chance of a 100 bps increase. Investors should recognize that these are the probabilities currently incorporated into securities prices. Using the same framework that we established previously, we believe a 75 bps increase in November would, with all else equal, likely be a small catalyst for stocks, while a surprise 100 bps increase would likely lead to further decreases in equity prices.
In the end, nobody besides the Fed knows what will come out of the November meeting. Well-constructed plans and portfolios should account for the impacts of market volatility and market downturns, so reach out to your financial advisor to ensure that your portfolio is still on track to help you achieve your goals. In the end, the best investment plan is one that the investor can stick with; if you find yourself uncomfortable with the market volatility we have experience thus far in 2022, engage with your advisor to determine whether or not there are necessary changes to make to align you with a strategy that you feel confident investing in long-term.
Glossary
The OECD Consumer Confidence Index measures future developments of households’ consumption and savings. Values above 100 are optimistic, and below 100 pessimistic.
The CAPE/Schiller Home Prices index is a measure of U.S. residential real estate prices.
