The Curtain Goes Up
Clients of the Firm,
Markets fell today, marking a pivot in sentiment and reflecting future interest rate expectations on the back of hawkish comments by Fed Chair Powell at the Jackson Hole Symposium. The text of his comments by be found here: https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm
The S&P 500 fell -3.37% today and closed at 4,057 a level -15.29% below the all-time high set in January 2022. The VIX rose +17.63% on the day and settled at a level of 25.62 which reflects the increased negative sentiment and corresponding volatility. Despite significant intraday volatility, bond yields across the curve did not change materially from the prior day close, indicating the bond market largely anticipated the hawkish comments from the Fed.
While stock pain was inflicted by the comments today, the strategy discussed by the Fed chair is not divergent from our expectations or our positioning. In addition, we do not feel the Fed is making a policy mistake by raising rates to fight inflationary pressures.
As discussed before, many inflationary pressures are out of the Fed’s control. Amongst these pressures are supply chain disruptions and the war in Ukraine creating food and energy price shocks globally. Ironically, these shocks are creating some deflationary pressure in the lower end of the retail consumer base because of higher core energy and food prices. This demand pressure has resulted in inventory builds and discounting at large discount retailers and lowered prices of retail goods as a result. Without these pressures, inflation would likely be much higher.
Rate increases by the Fed are having a major impact on the housing market as demand has slacked substantially. Covid boom town communities are seeing price declines in listings, but supply remains very constrained elsewhere and prices have not yet suffered.
In addition, rate increases are creating multiple compression in equity prices. We expect P/E multiples to normalize with rates which would result in a P/E compression to approximately 16 times forward earnings for the broad market. If rates increase substantially above normalized levels, we would expect to see further stock multiple compression. Conversely, if rates remain at the lower bound of historic norms we would expect P/E multiples to remain above normalized levels. Lofty valuations in private equity and the early-stage funding environment have also been impacted by these dynamics.
Strategically, clients should continue to own high quality companies at reasonable prices while collecting dividends from those companies as valuations settle to reflect current rates and implied risk. In addition, the opportunity created by higher rates means short-term Treasury rates continue to exceed 3%. Thus, short-term bonds and money market funds offer a reasonable positive return alternative if held to maturity.
Groucho Marx once said, “I didn’t like the play, but then I saw it under adverse conditions- the curtain was up.” Today, the Fed chair raised the curtain again on policy direction, which many market participants were hoping was not the play they were watching. Disappointing the audience, the Fed indicated it is still committed to stamping out inflation at the cost of the economic boom we have been experiencing the past year and half. While the play may not be good to watch, the Fed is delivering a necessary but not completely sufficient solution to the problem of insidious inflation. Our task is to navigate this transition in policy and try to avoid making short-term mistakes or acquiring assets at prices that would not make sense in a higher rate lower growth environment. As always, in our practice this goal is accomplished through a rational investing process based on price and fundamentals.
Thank you for your continued confidence in our firm, we appreciate the opportunity to serve you through this dynamic time.
Sincerely,
Peter C. Wernau
President, CEO
Wernau Asset Management
http://www.wernauassetmanagement.com/
Office: 617.871.0029
Fax: 617.507.8155
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