The good news is fourth-quarter GDP set a blistering pace of 6.9% lifting 2021’s full-year growth to 5.7%. The bad news is the economy is running hot and exceeding growth expectations. Now the Fed has a clear path to boldly raise interest rates to fight inflation. Fed Chair Powell has indicated a drop in markets won’t cause him to reverse course this time. He believes this strong trending economy can withstand a rate hike cycle without falling into a recession. The Goldilocks scenario is called a soft landing.
A Word of Caution
Boy, that sounds good, doesn’t it? A word of caution. Under these circumstances, the Fed has never engineered a soft landing without pushing the economy into recession and cratering the markets. In the past, the Fed has raised rates too aggressively and for longer than necessary to curb inflation. Each rate hike takes about six months to work its way through the economy. Yet, the Fed will likely raise rates at each quarterly meeting at a minimum.
The compounding effect of serial rate hikes on the economy is like pumping the brakes harder and harder on a car to slow down. Each hike slows the economy until the combined effect stops growth altogether. And if the economy is not growing, it will likely be contracting. The robust consumer spending we have enjoyed over the past ten years has been built on the back of zero interest rate policy. It’s cheap to borrow. In addition, the Fed and the government have pumped cash into consumers’ pockets with QE and fiscal stimulus. SO not only is the Fed taking away the zero interest punch bowl, but they are putting a hard stop to their QE balance sheet expansion at the same time. The net effect will be a constrained consumer who normally drives 70% or more of our economy.
Investors Typically Seek Value in a Downward Trend
The direction the markets take as the Fed shifts from policy accommodation to tightening seems pretty obvious. Just in case you are still wondering — that would be down. The Fed is way behind on keeping inflation under control, and they will respond by playing catch up. I’d expect a 50 basis point rate hike in March with more to follow. Investors have already started to react by selling the most overvalued growth stocks and rotating to reasonably priced value stocks. We have found investors prefer high-yielding dividend stocks even more under these conditions. In the Dot.com bear market, higher-yielding dividend stocks defied the harsh 50% or 80% corrections by the S&P 500 and NASDAQ, respectively, by posting positive returns. Hold it, did you say positive returns?
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Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
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