The market is off to a rough start in 2022. Tech and high growth are leading the way down and are likely to remain weak. Especially the ones that have seen a huge rally during the COVID period and have lofty expectations. Most of those have narrow moats and the valuations are still high, despite the pullback.
Meanwhile, Value stocks have not been immune to the rough start to 2022, but have held up materially better:
The bottom line is that when the Fed meets in March to consider hiking rates, the market might not be surging to new highs like it was at their December meeting when they were projecting rate hikes in 2022. If this volatility persists to March, the Doves will have a stronger argument to limit rate increases. Some on Wall Street are starting to project 4, 5, or even 7 hikes. They are making these projections despite comments like that of Harker, who sees four hikes as appropriate. Harker is one of the more hawkish members of the Fed.
If you’ve been following my writings, you are likely already well-positioned to protect your portfolio and your income from inflation. Investors need to consider that this is not a 20th-century FOMC. The Fed is getting more dovish and inflation will run above the 2%-ish target we are accustomed to.
What Is A Dove, What Is A Hawk
We have been throwing around the terms “Dove” and “Hawk” to describe the Federal Reserve and its actions. Let’s take a closer look into what those terms mean.
“Dovish” policy simply means any Federal Reserve policy that results in low/lower interest rates. When the Fed cuts the target rate, that is “dovish” because it lowers rates. When the Fed buys Treasuries, that results in higher Treasury prices and therefore has a lowering impact on rates, so it is also considered a “dovish” policy.
“Hawkish” is the opposite. Any policy that would result in higher interest rates like raising the target rate or selling off Treasuries held by the Fed would be described as “hawkish”.
It is important to note that the Fed typically does not have clear-cut lines. Most Federal Reserve members, over the course of their term, will vote for both dovish and hawkish policies depending on conditions. So when we say someone is “dovish”, it does not mean they will always take the dovish policy action. Even the most ardent doves will occasionally vote for a rate hike and even the most hawkish hawks will vote for rate cuts.
However, there is an ideological divide. Some members of the Fed think controlling inflation should be a higher priority, while others don’t see inflation as a problem.
The “old school” hawkish thinking that has dominated the Fed since the ’80s is dying out. For 40 years, the Fed has reacted swiftly at even the perception that inflation might be accelerating. Most members of the Fed saw preventing inflation as something that had to be done proactively – no doubt strongly influenced by the 1970s.
Today, we see most Fed members following a much more dovish line of thinking. They see the Fed as having erred on the side of keeping inflation too low over the past decades. They tout the benefits of low interest rates to growth and often with an ideological bent towards the favorable impacts of modest inflation for the working poor. They are much more tolerant of inflation and see it as something that the old school of thinking exaggerated the risks. They see the other part of the Fed’s mandate, “maximum employment” as a higher priority that should be achieved even at the expense of higher inflation.
Below is the Fed’s “dot plot”, graphing the responses of the question posed to each official asking where they believe interest rate policy should be in a given year. This is the “Target Rate”, which is the overnight lending rate that is set by the Fed. This rate has a significant impact on short-term interest rates.
Each dot represents one member. Note the “longer run” is the long-term goal. This is what each member sees as the “neutral rate” or the rate that strikes the ideal balance between growth and controlling inflation. It is mostly theoretical, but when two people have different destinations in mind it has a huge impact on the routes they take!
As you can see, the “longer run” category 2.5% is the most popular target rate that is seen as the long-term target. Six members believe the target should be lower, only two that it should be higher. Note, that this is an extremely dovish change from 2017, shown below:
In 2017, only the most dovish board member was targeting 2.5%, most were targeting 3.0%! Even that was a very dovish turn for the Fed which in 2015 was targeting 3.9% by 2019. The actual target rate peaked in Q4 2018 at 2-2.25%. So the Fed doesn’t have a very good track record of ever reaching its long-run targets.
In 7 years, the Fed’s average long-run target has declined from nearly 4% to 2.5%. That is very significant and explains why the actions we have seen in the Fed over the past three years have not aligned with historical actions. Let’s look at the actions this Fed has taken since Powell took the chair:
- Started reducing the balance sheet, only to do an about-face and resume buying treasuries and mortgages. The Fed started “easing” policies before any sign of recession, buying half a trillion in assets (previously known as “a lot”, in the “good ‘ole days” before 2010).
- The Federal Reserve started cutting rates in 2019, 9 months before the COVID crisis. The Fed cut in July, September, and October, from 2.25% to 1.5%.
- The response to COVID was record-breaking in its speed and aggressiveness. Adding $3 trillion to its balance sheet in support of the economy.
- In the face of rising inflation, the Fed has been slow to react. Even as inflation is at multi-decade highs, the Fed is still buying assets.
Judging by its actions, the Fed is already far more dovish than it has been in history.
The Fed Will Get More Dovish Soon
The current Fed already leans towards the “dovish” side. Biden has recently nominated three new members who will fill vacancies on the Federal Reserve Board.
- Sarah Raskin: A former Fed Governor from 2010-2014 when she left to join Obama’s treasury department. She was known as a dove back then and believes that the Federal Reserve needs to be taking on a larger role on climate issues and she doesn’t mean just by driving Tesla’s to work. She is a proponent of using Fed stimulus to support banks that are lending to “green” initiatives while increasing reserve requirements for those that lend to “fossil fuel” companies. If approved, Raskin will be coming into the Fed with a laundry list of policy goals, and controlling inflation is conspicuously absent from them. More to the point, an activist Fed like she envisions would most likely lead to higher inflation in energy, which has inflationary impacts throughout the economy.
- Lisa Cook: We have little tangible evidence of Cook’s beliefs regarding Federal Reserve policy. She is an economics professor in Michigan that has no history with the Federal Reserve. Her academic articles have generally focused on racial and gender disparities in wages. In terms of “maximum employment”, we are willing to bet she will be among the members who look at employment by demographics as opposed to the more old-school method of just looking at the headline unemployment metric. This suggests we can expect a more dovish lean.
- Philip Jefferson: Another nominee that comes from academia, though was employed by the Federal Reserve as an economist in the 90’s. Doing a survey of his writings, we can be quite confident that he falls on the “dovish” side of the fence as well and has written about the virtues of a very tight labor market.
These three new members will be replacing Quarles, Clarida and filling the vacant seat left by Janet Yellen. Quarles and Clarida are both considered moderates, and we believe the nominated group is materially more dovish.
The FOMC Will Get Even More Dovish Next Year
The FOMC (Federal Open Market Committee) is the body that votes on actions like setting a target rate and market activity from the Fed like quantitative easing. When people say “the Fed”, this is usually what they are talking about, even though “the Fed” is larger. On the FOMC, the Board members appointed by the President, the President of the Federal Reserve Bank of New York always get to vote. The remaining four positions come from the eleven remaining Federal Reserve Presidents on a rotating cycle.
In 2023, there will be a huge shift with very dovish members gaining voting privileges while a few of the more hawkish members lose their vote.
As discussed above, Quarles and Clarida will be replaced with nominees from Biden. Plus the third nominee replacing Yellen’s currently vacant seat will add weight to the dovish side. After those new nominees take their seats, the FOMC is likely to be more dovish than it is today.
Then in 2023, Kashkari and Evans, two of the most dovish Federal Reserve Board members will gain votes. In short, what is already a very dovish FOMC will become even more so next year.
While some hawkish pressure might come into play in 2022, anything done this year can quickly be undone next year as the doves move from being a major influence to being fully in control. The slight toehold that the more hawkish members have today will be gone.
Why It Matters
As investors, there is no getting around the reality that the decisions made by the Fed have a substantial impact on the markets. We need to keep that in mind as we position our portfolios.
What can we expect from a more dovish Fed?
- Federal Reserve’s target rate might be raised in the near-term, but will be brought back down at the first sign of economic weakness. The current Fed is much more likely to look at unemployment among various demographics as opposed to the headline number. So if unemployment is elevated among one demographic, they won’t care if the overall unemployment rate is very low. Doves consider a tight labor market a positive, even if it does add to inflationary pressures. “Maximum employment” is the top priority, managing inflation is secondary. When those two goals come into conflict, we can expect the doves to be more willing to allow inflation to be elevated.
- The long-term goal for the target rate will go lower. 2.5% is currently the most favored target, as more dovish members join the board we will likely see that target come down further. Perhaps as low as 2.0%. A lower long-term goal means that the Fed will be slower to raise.
- A greater willingness to expand the balance sheet for longer. We’ve already seen an unprecedented increase in the Fed’s balance sheet. More dovish members don’t see this as a problem and are less likely to be aggressive about trying to shrink it.
- More of a focus on social issues. Another common thread among the new doves coming in is that they have all expressed a desire for the Fed to become more proactive at using its tools to address social issues like green energy, poverty, racism, sexism, etc. Historically, the Fed has been seen as “apolitical”, it allegedly made decisions based upon mathematics. That perception could change over the next decade.
What This Means For Our Investments
Tying it all together, we can expect interest rates to remain historically low. When the Fed was targeting 3%+, it failed to get close. Going forward, the long-range target will be lower, and I believe even a lower target will be missed. It is very likely we won’t see the Fed target rate at 2.5% this cycle.
As a consequence, we can expect that inflation will be allowed to maintain an above-average pace. We’ve already seen the Fed edge up its PCE projections up to 2.1% through 2024 and 2.3% for 2023. In other words, the Fed is not in a hurry to control inflation. It is perfectly fine with allowing inflation to be above average, even if it considers 6% too high. With the doves gaining more voting power, we can expect the Fed to be even less concerned with inflation. We should set our inflation assumptions accordingly. Instead of assuming under 2% as we have in the recent past, we need to assume inflation of 3-4%.
As we are investing, we want to avoid companies that have excessive exposure to labor. Companies with substantial labor expenses are going to see margins compressed as they are forced to compete by raising wages and/or reducing production. Financials, REITs, and BDCs will have a leg up as these business models manage large amounts of capital with relatively little direct labor expenses.
The bottom line is that the Fed is set to become more dovish. As investors, this means that rate hikes will likely be lower and slower than some of the extreme projections we are seeing. Interest rates are likely to remain lower for longer and are unlikely to reach the levels we saw last cycle.
In short, we are likely to see inflation continue to outpace interest rates. Real yields on treasuries are likely to remain negative, which is very bullish for equities. When picking investments, investors should consider the impacts of inflation. 2022 will be a year for stock pickers, with some companies doing very well, while others sell off aggressively.
How did your portfolio fare in January? If it outperformed, then you are in holdings that will fare well in a high-inflation environment. If your portfolio fell more than 10%, then maybe it is time for you to consider repositioning for 2022. In a high-inflation, low interest rate environment, dividend-paying equities will outperform.
Your retirement is depending on it.