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Fears that Rising Interest Rates Will Lead to Recession

7/5/2022

But opportunities remain for stock investors if you know where to look.

In response to surging inflation, the Federal Reserve raised short-term interest rates by 75 basis points (0.75%) at its June meeting. and expectations are for a similar hike in July. The Fed does not meet in August and November, meaning there will be three more meetings this year after July. Expectations are rising that aggressive rate hikes at these meetings will make up for lost time.

A frustrating thought is that it didn’t have to be this way. After all, we are only a little over two years past the last bear market and recession, both of which were deep but brief. This time the causes are largely man-made. Even after the economy was clearly past the worst of the pandemic, the government spent too much money continuing to boost demand and the Federal Reserve continued to print money. Those actions left policymakers with no room to maneuver when supply chain issues and Russia’s invasion of Ukraine added to the normalization of inflation that began when the economy re-opened over a year ago. The Fed was injecting money into the economy as recently as March 2022 before it began to raise short-term interest rates to tamp down surging inflation. Inaction deprived the Fed of the chance to raise rates gradually and now it has little choice but to accelerate its interest rate hikes, boosting recession risks.

The bond market used to discipline the government by causing market interest rates to rise even if the Federal Reserve took no action, producing the nickname “bond vigilantes.” However, yields on the bellwether 10-year Treasury Note were well behaved until just recently. Treasury rates were in the 1.25%-1.50% range last summer and around 1.5% as this year began. This led us to question whether our concerns about unneeded spending and overly accommodative monetary policy simply reflected excessive caution on our part or whether the Fed’s purchases of Treasury securities interfered with the interest rate signals that in the past served as a canary in the coal mine. Recently, Treasury rates hit 3.48%, the highest since 2011, inflicting losses on bond investors.

There appears to be no letup in inflation. The Consumer Price Index (CPI) rose an astonishing 8.6% over the past 12 months through May. If there is any consolation to be found in the report, the so-called “core” CPI gained 6.0%, a slight slowdown from the 6.2% rise through April. The difference between these inflation measures reflects the impact of surging energy and food prices, both of which are excluded from the “core” index. This exclusion is fair when temporary factors like weather cause fluctuations in food and energy prices, but they are a very real (and growing) part of household budgets.

Stock market action implies that recent Fed rate hikes may lead to a recession, likely sometime in the next year. We don’t say this as economists, but as watchers of investor behavior. The S&P 500 and Nasdaq are well into bear market territory, defined as a decline of 20% or more from the previous peak. The Dow is not there yet. A bear market is more than just an arbitrary number, however; it is a state of mind. Investors have been exhibiting bear market behavior over the past month or two. In a normal market, favorable company developments are rewarded with higher stock prices; bad news causes prices to decline. In a bear market, investors are inclined to take only one action: sell. Bad news brings about the expected decline, perhaps worse than in a normal market. However, in a bear market even good news is frequently met with yawns rather than cheers.

Right now, there are still numerous opportunities to position portfolios for success in the inevitable upswing by trading up to even better companies, such as the large software company, automobile seller, and industrial tools manufacturer profiled in the July 2022 issue of the award-winning, market-beating Investor Advisory Service stock newsletter.


Reprinted from the July 2022 issue of the Investor Advisory Service stock newsletter, rated #1 for performance in 2021 by Hulbert Ratings.

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