How to Make Sense of the Fed’s Shock Therapy and the Road Ahead

For about 105 minutes on Wednesday afternoon, financial advisors and their clients had a chance to exhale. The Federal Reserve’s decision to raise lending rates by three-quarters of a point fueled a temporary relief rally as the major indices finished the day solidly in the green.

Jerome Powell, chairman of the U.S. Federal Reserve

Al Drago/Bloomberg

By Thursday morning, the market pivoted back into selloff mode, as major indices slid right back into the red. Although advisors have no way of knowing whether the Fed’s coming summer of aggressive rate hikes will have a clear impact on inflation, they can at least start to hope that market volatility begins to wane. The CBOE Volatility Index (“The VIX”) has moved back above 30, which is bound to keep many dip-buyers on the sidelines.  

Many advisors have been preaching patience, asking clients to hold tight and ride out the current stress. Yet patience eventually wears out. Clients are growing cranky as they are told to endure the trauma of a drop in their portfolios. Some of them may eventually bolt to another advisor who promises a fresh start. (As we saw during the 2008 financial crisis, client defections can rise during bear markets.) Others may thank you for your calming wisdom, though perhaps not until markets have rebounded.

Communication is key, and those clients need to hear from you. Tell them why you remain steadfast during daunting times, and explain what new opportunities may soon lie before us. Take the fixed-income markets as an example. We now know that the bulk of the Fed’s further rate hikes may take place during the late July and early September Fed policy meetings. Further rate hikes may come in the autumn, but not at the half or three-quarters of a point rate per meeting we’re enduring now. By then, much of the interest-rate risk may have come out of the bond market, and the yields on offer should look quite impressive. 

For my clients, that means a move into short-term corporate bonds later this summer. The yield on the Vanguard Corporate Short-Term Bond ETF (VCSH), for example, has just moved up to 3.7%, and after the next pair of rate hikes, it could be closer to 5%. If clients can get that kind of yield with the bulk of price risk behind them, they’ll be grateful for your guidance.

Similarly, municipal bond yields have been backing up, and the after-tax yields on many of them are now well above 5%. In addition, mortgage-backed securities (MBS) are offering increasingly fruitful yields.

Again, it may be a tad premature to quickly shift bond positions now as the interest rate complex remains volatile, but calmer days lie ahead as we move past the Fed’s “shock therapy” phase. 

Why do I think that the Fed will be close to the end of the rate hike cycle by the Federal Open Market Committee meeting in September? Because the economy is already slowing and by then will have slowed to the point that the Fed wants to pull up short of inducing a full-blown recession. As it stands, rising rates are already creating headwinds in areas such as the housing market. 

To spot eventual opportunities in equity markets, it helps to explore the variation of returns in various asset classes thus far in 2022. Value stocks have fared relatively well. The

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Vanguard Value ETF (VTV), for example, has fallen less than 13% in 2022 (through midafternoon Thursday), while the Vanguard Growth ETF (VUG) has fallen more than 33% 

The small-cap-focused Russell 2000 is now off about 27%, which is to be expected when an economy slows and a recession looms as a possibility. (More on that in a moment). 

For advisors, a pair of questions arises: Should certain clients be prepared to wade into these fallen market segments, now that they are in the discount bin?; and will those clients have the fortitude to follow your lead, or will they remain in a fear-driven crouch?

Let’s consider the case for small-caps. Once an economic slowdown or eventual recession is priced in, they tend to post a furious snapback. As just one example, the U.S. economy entered into recession in late 1990 and began to grow again the following summer. Yet the Russell 2000 rose a stunning 53% from Oct. 16, 1990 through the following 12 months. Again, that rally came even as a recession played out. The market, as they say, always looks ahead. 

Of course, this is a sensitive conversation with clients. They’re hurting and may not welcome any conversation that focuses on new investment opportunities right now–let alone those that are emerging in riskier asset classes such as small-caps, growth stocks, and emerging markets. It’s our job to listen to their concerns and still have the ability to steer the conversation toward holding course now and embracing the buying opportunities when they come. And come they will.

All through the late stages of the recent bull market, clients did the heavy lifting to tilt their portfolios in a more conservative direction, owning more value than growth and shunning duration in the bond market. During that time, it grew increasingly evident an eventual market selloff would enable those shelter-seeking investors to venture back out onto the risk curve, following the Warren Buffett maxim to “be fearful when others are greedy, and greedy when others are fearful.”

It may not be comfortable to verbally express such sentiments, which is why many advisors have increased the cadence of their written communications to clients. 

For clients who don’t want to wait for the “summer of sharp rate hikes” to play out, various options strategies could provide more timely opportunities. Further opportunities are in place in the alternatives market (funds known as “liquid alts.”). Managed futures strategies, most of which thrive on volatility, are having an epic run. Of the 77 such funds tracked by year-to-date gains range from 16% up to 55%. Managed futures funds offered by AQR Capital Management and Alpha Simplex have been especially stellar this year.

While the options market and liquid alts can thrive in a period of extreme volatility, it’s also important to look ahead to the investment strategies you’ll be deploying when markets calm down. Explain your thinking with clients now so they’ll be ready to take action when volatility recedes. 

David Sterman is a journalist and registered investment advisor. He runs Huguenot Financial Planning, a New Paltz, N.Y.-based fee-only financial planning firm. 

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