Welcome to another episode of “Ethel’s Diamond Post.” In case you haven’t heard, the Federal Reserve raised interest rates by .75 basis points last week. Was that a surprise to anyone? Probably not. Why? The Federal Reserve’s goal is to put inflation behind us by raising interest rates for the third time this year. As consumers, we feel the pain at the gas pumps, and the grocery stores, with the supply chain challenges being critical factors in the “runaway” inflation saga. Like frequent flyers of Southwest Airlines, investors expected some turbulence, but the recent declines that led the S&P 500 to hit a new low might have been an extreme surprise to many investors. The Dow Jones Industrial Average’s drastic drop put the index into an official bear market territory. This market cycle will require patience and lower expectations regarding the overall performance of the capital markets. The range of outcomes is broad, but several positive or negative scenarios could come from this environment, including a moderate recession.
Remember, as inflation began to rise in early 2021, the “talking suits” at the Federal Reserve and Department of the Treasury said there was little concern it would stick around and that inflation would likely fall by mid-2022. However, at the beginning of 2022, the experts changed their minds and began talking about raising interest rates aggressively to curb the rising levels of inflation. Jerome Powell, Chair of the Federal Reserve, forecasted “some pain” ahead for households and businesses. Persistent inflation will take a toll on consumer spending and the overall economy; when prices of goods and services rise, the economy forces supply and demand to find an equilibrium point. From the demand side, the market tends to drop as prices rise, which creates too much inventory, and eventually, prices fall again. As the cost of living swells, the market volatility will increase until we find a soft landing for inflation.
The S&P 500 lost approximately 8 percent this month, especially with yesterday’s extreme sell-off. At the same time, commodities buckled under the weight of a rising dollar compared to our international cohorts. The U.S. Treasury yields continue to rise, with the 10-year rate climbing as much as .21 basis points to 3.898 percent, the highest level since April 2010. Regrettably, this process needs to play out because the Feds will not stop, and the market is attempting to price this into the day-to-day volatility. Fear has overcome greed, and retail investors are not widely buying on the dips, but institutional investors realize that everything is on sale. Yet, a broad sell-off is offering a buy signal to contrarian investors. No one’s crystal ball is 100 percent all the time. Therefore, we will take a more conservative approach until the inflation dust settles down a bit more.
At VZD CAPITAL MANAGEMENT, LLC, we understand that nothing remains the same. Change is good, especially when you are an active portfolio manager versus a passive approach. Our priority is preserving capital, increasing income generation, and remaining loyal to a growth-at-a-reasonable methodology. As a private wealth manager, we purposely keep our client-to-portfolio manager ratio low to ensure our clients receive our undivided attention and monitor investment trends daily. Therefore, we can transition without the bureaucracy that often plagues the larger investment firms. So, what is our game plan?
- We have researched the fundamentals to determine which companies, sectors, and industries are sensitive to interest rate fluctuations and which are inflation-proofed, anticipating future hikes. Companies that can pay a significant dividend through a rising inflation environment stand to offset purchasing power erosion. We will decrease our equity exposure but keep the quality dividend-paying companies.
- We screen and continue to purchase companies trading below their intrinsic value relative to their fundamentals (dividends, earnings, sales, book value, and price-earnings-growth ratio). Some industries that fared well in the past include financial, consumer staples, and real estate.
- Next, we are implementing Treasury Inflation-Protected Securities (TIPS) into portfolios to reduce the volatility due to rising rates now and soon. The U.S. Treasury sells TIPS and adjusts their par value annually to track inflation. However, these investments do not provide capital appreciation, and interest payments will decrease as inflation falls.
- Many times, Real Estate Investment Trusts (REITs) are another tried and true hedge against inflation that lends itself to the ability to hold real estate in a more liquid route. Rates from rental growth generally increase over time as the population increase, and the supply of new property typically declines in times of high inflation. The scarcity helps drive appreciation for undeveloped land and other real estate types. Most investors select real estate because it does not typically correlate too closely with bonds or stocks.
- Another hedge against inflation is gold, silver, and other precious metals. The primary reason is that precious metals’ intrinsic values never go to zero, especially gold.
So, what will we do? We will transition more into cash, being in a position to take advantage of moves in the capital market and the bond market. Fixed income has become extremely attractive, but we will use caution, for there will be more hikes before year-end. The Federal funds rate is 3 percent to 3.25 percent, the highest level since the 2008 financial crisis. The estimation is for the benchmark rate to rise to 4.4 percent and 4.6 percent by year-end. Therefore, this implies a fourth-straight 75 basis-point hike could be on the table for the next session in November, a week before the U.S. midterm elections.
Please know we will continue taking long-term gains and minimizing growth-oriented companies immediately. We encourage our clients to be mindful of spending practices as we transition into this new season. For our retirees, we will make sure to pay out your required minimum distributions for this year to avoid tax penalties. We understand that our clients deserve professionals to ensure their financial health, and well-being is our fiduciary responsibility regardless of wealth levels. With our combined 36 years of experience within the investment and legal communities, we complement each other by being a fee-based, registered investment advisory firm. Our compensation depends solely on your success, so all hands are on deck all the time.
We appreciate the continued trust and confidence you have placed in us. Please call if you have any questions or concerns as we transition into this new economic environment. Remember, this, too, shall pass, and we are grateful for your continued support and referrals.