The Hawks are Circling

The third quarter was quite a ride, adding to a painful year for investors. The market was strong in July and the beginning of August on a misreading of Federal Reserve Chairman Jerome Powell’s remarks. The market was hoping for a Fed pivot, and was beginning to price it in. We saw it as a head fake and took advantage of the strength in the market to take risk off the table.

In mid-August the market started selling off as Powell confirmed at Jackson Hole that his stance remained decidedly hawkish and the Fed was committed to continuing to fight inflation. Powell was very clear, there was nothing ambiguous about his message: “Restoring price stability will likely require maintaining a restrictive policy stance for some time… The historical record cautions strongly against prematurely loosening policy.” The rest of the quarter was painful.

Unfortunately, we expect volatility to persist in the fourth quarter. October has historically been a difficult month for markets, especially ahead of a midterm election. With so much attention paid to hot inflation, the war in Ukraine, and the market selloff, the midterm election is only now starting to come into focus. This election is important because control of Congress is at stake. Looking back through history, the President’s party typically loses ground in Congress in the midterms. With President Biden’s low approval rating, this time is unlikely to be different. If Republicans take back control of the house it will decrease the chances of far-reaching Democratic legislation being passed over the next two years. Historically the election has brought certainty which has fueled a positive market reaction. Unfortunately, there are other factors that are likely to overwhelm this historical trend.

Interest rates are at the highest level since 2008, and with September’s inflation report coming in hot, we don’t see them coming down soon. While headline inflation may have peaked, we think below 2% inflation is unlikely for a long time.

The Fed is determined, unanimously, to bring inflation back down below 2%. As the saying goes, don’t fight the Fed. The headwinds are here to stay for now. There are major concerns here. First, monetary policy acts with a lag. The Fed arguably already made a policy mistake by leaving monetary policy ultra-accommodative for far too long. They are being forced to hike too quickly, unable to see the effects of the prior hike before making their next decision. This increases the likelihood that they go too far. On top of the Fed hiking rates which increases debt servicing costs for the government, corporations, small businesses and consumers, banks are increasing lending requirements, fiscal policy is less stimulative, food and energy prices are hurting demand for other goods, and a stronger US dollar is increasing the cost of our goods abroad. The Fed has taken away the punch bowl and, as the party ends, we are going to see who drank too much.

The bond market continues to flash a recession warning signal with an inverted yield curve and there is some evidence the economy is slowing. Retail sales are barely keeping up with inflation, ISM manufacturing readings have slowed, some bellwether stocks have disappointed on earnings, and JOLTS (Job Openings & Labor Turnover Survey) job openings fell in August. The US Federal Reserve hiking rates tightens financial conditions globally.

We have been saying that one of the biggest challenges this cycle is the inflationary pressures are on the supply side, not the demand side. The severe labor shortage is unlikely to resolve quickly. Aging demographics means the size of the labor force (producers) is shrinking, while the number of consumers is still growing slightly. This is inherently inflationary. Supply chain issues are also still being worked through, the war in Ukraine continues on, and trade relations with China seem to be worsening again. These are not things the Fed has control over. They risk cutting off demand completely while having only a moderate impact on inflation.

As we enter earnings season we expect more disappointments. We still do not believe that earnings estimates have been revised to reality and we also believe that the multiples being paid for companies continue to be too high for the environment we are in.

We are positioning client accounts to be more defensive in todays’ environment. We are very underweight equities as a whole and are tilted towards the more defensive areas of the market. We are slowly moving into consumer staples, healthcare and utilities. We also have more exposure to quality companies that are earning money and have solid free cash flow today. Companies that don’t have a lot of debt and don’t have to take on more debt to tread water. We want companies that have relatively stable margins and sales during difficult economic environments. These companies should remain resilient in the face of tough economic times.

We are at the top end of our allowable cash range and are deploying capital as we see appropriate opportunities for the current environment. We are at the bottom end of our allowable equity range and are likely to stay there until we see signals the economy has washed out and valuations are discounting reality, or the geopolitical environment greatly improves. The fixed income market, specifically the treasury market, is starting to look more compelling which is prompting us to incrementally start moving cash there. We are also seeking increased diversification in this environment. Allocating capital to things that are less correlated from the rest of the portfolio such as gold.

As always, please reach out with any questions.

Kasey

MGO One Seven LLC (“MGO One Seven”) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. Services are provided under the name Stone Creek Advisors, LLC, a DBA of MGO One Seven. Investment products are not FDIC insured, offer no bank guarantee, and may lose value.