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The past few years have placed investors up against tightening conditions. What are some causes, and what does the future hold?

In this market environment, investors have had no choice but to balance several complex issues related to tightening financial conditions. These have ranged from rising rates to a slowing economy and a housing market downturn to the current banking crisis. While each of these issues has its own unique circumstances, it’s also essential to recognize the common underlying causes. This is especially important as the situation evolves and the financial system continues to adjust to Fed rate hikes. What do investors need to know about tightening financial conditions as they stay invested for the long run?

At its recent March meeting, the Fed announced that it would raise rates another 25 basis points, pushing the fed funds rate to a range of 4.75% to 5.00%. They did this despite the recent runs on banks, reiterating that, “The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring and inflation”.

In other words, the Fed’s view is that the problems in the banking industry will naturally tighten conditions, reducing the need for larger rate hikes. Despite the many calls for the Fed to cut rates, part of the Fed’s calculus is likely that overreacting to these banking problems would spark more panic, not less.

Markets expect the Fed to cut rates later this year.

The Fed also published its Summary of Economic Projections, which showed that officials expect growth to slow to 0.4% in 2023, unemployment to rise to 4.5% (from 3.6% today), and PCE inflation to decelerate to 3.3% (from 5.4% today). Fed officials also expect the fed funds rate to rise by another 25 basis points and remain there for the rest of the year.

This is at odds with what the market expects. Fed funds futures show that investors believe the Fed might hike again in May but will need to begin cutting rates soon after. Over the past year, the market has arguably been ahead of the Fed. Thus, despite what the Fed might do in the coming months, it is likely that we are in the midst of an inflection point in financial conditions. Please note that the European Central Bank and the Bank of England also raised rates recently, although they face much more severe inflation challenges.

Since the Fed began hiking rates to fight inflation a year ago, many economists have worried about financial stability and the possibility of a recession. Many episodes over the past century, including the Great Depression and the mid-2000s housing bubble, show that the Fed tends to be reactive – that is, it often keeps policy conditions too loose for too long before tightening aggressively. This is partly because the Fed only has blunt tools that operate with a lag. It’s also because the Fed relies on broad economic indicators, which are only published monthly or quarterly, with an eye toward the factors that caused the last crisis.

This approach has several implications today. On the one hand, the probability of a “soft landing” is still highly dependent on inflation, the labor market and economic growth, just as it has always been. When it comes to inflation, there are many positive trends. For the most part, inflation rates are improving. Some measures, such as goods inflation and core inflation excluding shelter, are already at or near the Fed’s target. For investors, markets have also performed better this year across stocks and bonds compared to 2022 due to reduced inflation risks.

CDX spreads have only widened slightly.

On the other hand, the economy is experiencing a hangover from the easy money policies of the past 15 years. Loose monetary policy can spur asset bubbles, and this arguably occurred in startups, tech and crypto, with the benefit of hindsight. The popping of these bubbles is necessary and healthy but has near-term repercussions across the financial system. This echoes historical episodes during which Fed rate hike cycles led to financial instability in banks or across companies and countries that depend on cheap financing. A decade ago, for instance, a group of emerging market countries dependent on external capital, known as the “fragile five,” ran into problems when the Fed began to tighten conditions.

Thus, the current banking crisis is only one of the repercussions of the monetary tide that has gone out. While this is still playing out, and it’s unclear how at-risk regional banks and large European banks may ultimately fare, the situation has also stabilized. The first wave of panic that drove depositors away from these banks appears to be subsiding, and every day that passes should bring more calm.

To gauge whether this is the case, investors are closely watching spreads on credit default swaps – financial instruments used to track and hedge default risk. As expected, these spreads widened for at-risk banks but, at the moment, are still within manageable levels. The accompanying chart of the CDX index – a benchmark of default risk across companies – shows an uptick. However, levels are still below 2020 and 2022, especially for the highest-quality issuers.

Fixed income has helped to stabilize portfolios this year.

What does this mean for investors? Within the S&P 500, regional bank stocks have struggled, falling 34% year-to-date, and the broader financials sector has declined 9.4%. Meanwhile, the broader S&P 500 has gained 3.4%. This is because industries such as Information Technology and Communication Services have risen 17.5% and 18.4%, respectively, over this same period. Market swings have been more pronounced throughout this episode. Still, it shows the importance of staying diversified across and within markets.

Throughout the challenges this year, a diversified basket of fixed-income securities has gained 3.4%, driven by Treasuries, mortgage-backed securities, corporate debt and more. An essential driver of the gains in these sectors has been the decline in interest rates, despite ongoing Fed rate hikes. This has helped re-establish the negative correlation between stocks and bonds that have helped long-term investors for over four decades. This is a reminder that diversified investors focusing on longer time horizons are more likely to stay on track, with a much steadier ride, than those that overreact to every new headline.

The bottom line? Despite the big market and financial events this year, the best course of action is still to stick to well-constructed portfolios and financial plans.

If you have any questions about your portfolio, your plan or your future,  click here to schedule a meeting with me, or call our office at (843) 743-2926. We are here to help you, and we look forward to developing a plan that gives you confidence in your long-term strategy!