In April, the Consumer Price Index (CPI) slowed to 8.2% year-over-year, coming down from 8.5% in March. Even though the majority of price increase are coming from energy and food, considered the more volatile parts of inflation, the Federal Reserve (Fed) acknowledged a need to regain control of prices. As part of the Fed’s dual mandate (full employment and price stability), inflation which is near 40-year highs is now squarely in the cross hairs of the Fed.
On the first Wednesday of May, the Fed approved the first 0.50% rate increase in the Fed funds rate in more the two decades. This policy change was preceded by a 0.25% rate hike in March, bringing the Fed funds rate to a range of 0.75-1.00%. At the time of writing, the markets are pricing in the Fed funds rate to end the year around 3.0%. While higher rates and lower fixed income prices is a common connection, the connectivity does not stop there. The reverberating effect of higher interest rates has shown its impact throughout the market.
Higher rates showed their sedative powers on highly priced stocks again in April, continuing the trend for 2022. The linkage goes like this:
- Often when valuing a stock an investor will look at the future earnings power of a business.
- To value those future earnings in today’s dollars they will use a discount rate which has typically had some connection to the Fed funds rate.
- The higher the discount rate, the lower the value of the stock.
So, higher rates lead to more conservative estimates of value. This has had a disproportionate impact on stocks that are heavily reliant on future earnings growth to justify their high valuations.
Higher rates do not just stop there. They also impact currency prices and thus far, the Fed has been more hawkish than other central banks, moving U.S. rates higher than those abroad. This in turn makes the U.S. dollar more attractive than other currencies and by extension, assets priced in other currencies are worth less in U.S. dollars if the dollar appreciates. U.S. dollar strength helps explain some of the U.S. equity outperformance versus international peers, but not all of it. International performance continues to roil around the rise and fall of geopolitical risks. While negative returns were prevalent across broad indexes and sectors, China continued to struggle. Down -3.7% in April and -17.63% for 2022 the world’s second largest economy was a primary detractor to Emerging Markets in April. Lingering concerns from policy reform in 2021, a slowing economy, tensions with the West and disruptions from strict COVID measures have all weighed on investors’ minds. While very few elements of these headlines are new, concerns of their collective impact have accelerated.
So where does this leave us? In many ways, with a similar outlook to how we entered the year. We discussed the hard road ahead for fixed income and the likelihood of volatility rising as the Fed walks a tightrope for a soft landing, as well as a greater focus on earnings for equities to advance. These factors remain present today and therefore reflect our current positioning in portfolios. We remain keenly focused on these events through our regular process by evaluating risk and opportunities. We continue to stress broad and thoughtful diversification to help maintain a resilient portfolio in what may continue to be a rocky environment.
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