Good news or bad?
The Federal Reserve raised the short-term benchmark interest rate by three-quarters of a percent on Wednesday, the largest increase since 1994. Just a week ago it seemed a half-point bump was likely, but recent inflation data prompted an even bigger increase.
On Monday stocks plunged following negative inflation news, but stocks responded favorably after the Fed’s rate announcement yesterday. Today it appears the market is unhappy once again. Markets have certainly been jittery (to say the least). What’s happening? What is good news and what is bad?
We are in no position to speak for financial markets (and frankly, neither are the talking heads on television), but there are reasons that markets might behave this way. Markets are made up of many participants with plenty of biases and emotions at play. Over the long-term investments do a pretty decent job of pricing in available information. In the short-run, emotions often rule the day. Although the future is always uncertain, at times it seems even more uncertain.
Sky high inflation is a glaring problem. On the one hand, aggressive action by the Fed demonstrates a strong commitment to dealing with the problem (a good thing). On the other hand, rising rates are intended put a damper on economic activity (a bad thing). It’s easy to see why President Truman purportedly exclaimed, “Give me a one-handed economist!” But economic issues simply are not one-sided; there are always pros and cons.
How do higher interest rates affect the “big picture” for investments? No one can say for certain, but we can take a look at history for some context.
Cooling the economy without overshooting is a difficult task, and a recession is a distinct possibility. Every recession is unique, but history tells us that most are relatively short. Recessions are not necessarily bad for stocks. Equities have actually risen during half of the 12 recessions since World War II, and in 4 instances stocks experienced a single-digit decline. In the one-year period following those 12 recessions, stocks posted substantial double-digit gains all but one time. In 6 of those 12 cases, stocks rose more than 25% for the year post recession. There is generally a bright light at the end of the tunnel.
On the bond side, yields have already risen significantly. That’s painful in the short-run as values drop to price in higher yields (as we’ve seen year-to-date), but those higher yields are a clear positive looking ahead. Interest payments are the driving force behind long-term bond returns, and interest rates have been kept artificially low for a long time. The opportunity to reinvest bond payments at higher rates is a definite plus for savers and retirees. For bonds that are currently owned, the cash flows remain exactly the same. When a bond is held to maturity, nothing changes – except that those payments can be reinvested and compound at higher yields in the future.
Bad markets are inevitable, but they don’t last forever and they are generally followed by rather good markets. The turning point, unfortunately, is never obvious. It takes discipline to persevere through the tough times, but the reward for weathering a storm is often a rainbow at the end.
We are here to answer your questions. Thank you for allowing us to work with you through these tumultuous times.