Substantial and prolonged quantitative tightening is not something seen in recent history and suggests volatility will become more commonplace in financial markets.
One thing seems likely: the next ten years will look different from the previous ten.
As QE shifts to QT, investors should consider how they construct portfolios going forward, particularly by adding greater diversification to a traditional 60/40 portfolio.
Is the U.S. economy now in a recession or are the fears of a recession still just circling? While two consecutive quarters of negative gross domestic product (GDP) usually indicates the economy has entered a recession, the actual decision could come months from now when the National Bureau of Economic Research makes the determination. Of course, considering rising interest rates, raging inflation, and record-high gas prices, recessionary concerns were not unexpected. Despite the uncertainty, one thing seems likely: the next ten years will look different from the previous ten.
Substantial and prolonged quantitative tightening is not something we’ve seen in recent history. It will likely mean volatility will become more commonplace in financial markets—and be sustained over longer periods. This means to reach financial goals, financial professionals should think more carefully about portfolio construction and what may best serve investors heading into the next ten years.
The Fed Put
Following the stock market crash in 1987, when Alan Greenspan was the chair of the Federal Reserve, he set a precedent that the Fed would intervene in the domestic markets in times of crisis. Nicknamed the “Fed put” or the “Greenspan put,” the Fed would promptly inject liquidity into the market by purchasing trillions of dollars of U.S. Treasuries after a significant drop in the stock market.
The success of these injections is shown below by the market’s response to the easing of the Fed’s balance sheet.
Fed Balance Sheet vs. S&P 500 Index
Source: currentmarketvaluation.com. Table data is since 1/1/2010-6/30/2022.
Such a stance on quantitative easing helped investors feel like they could take on more risk, knowing the Fed would likely throw a lifeline before the risk became too great. This created an artificial market environment performing differently than historical markets and unwittingly created a false sense of security for investors. The unchartered territory of this environment provided years of unprecedented equity growth and left investors feeling confident—perhaps too confident—about the market and their high-risk portfolios.
Applying the Brakes
Coming out of the pandemic with the U.S. economy reopening and stimulus money abounding, the Fed announced plans to begin tightening its belt. Many are unsure of what quantitative tightening will look like over the long term or the effect that the Fed’s quicker-than-historical tightening will have on the market, but the anticipation of quantitative tightening has quickly led to increased volatility in the market.
On the Rise
In March of this year, the Fed made its first rate hike since 2018 of 25 basis points with plans to make additional hikes throughout the year and into next. As inflation continued to rise, the Fed announced its intention to bump interest rates by 50 basis points at each of the future meetings. However, with inflation moving higher than anticipated, the Fed chose to raise rates by 75 basis points at both its June and July meetings; these were the third and fourth rate hikes this year, with June’s hike being the largest increase since 1994. Whether this aggressive stance will help stave off inflation or not is yet to be seen. We believe, however, that given the end of this artificially propped-up environment, investors should reconsider how they construct portfolios going forward, particularly how to add greater diversification to a traditional 60/40 portfolio.
Many believe the current market resembles the 1970s and early 1980s when inflation and gas prices rocketed to record highs. However, this time could be different. For starters, part of today’s high inflation is a result of pandemic disruptions. As the U.S. started to come out of the pandemic, there was high demand for goods from consumers armed with stimulus checks and hefty savings accounts. Factor in supply chain slowdowns and bottlenecks caused by lingering pandemic shutdowns globally, and you get inflationary pressure. While the Fed’s main policy tools are interest rates and asset purchases, these are blunt instruments and not designed to target nor quickly solve global pandemics or supply chain disruptions. In addition, much has been learned about inflation and its long-standing impact on the market since the ‘70s. Today’s Fed seeks to be different by being more transparent with its intentions, providing signals to the markets and the public.
Mounting Recession Concerns
As inflation has continued its rapid ascent, recession concerns have been building. While the academic definition of a recession calls for two-quarters of negative GDP growth, many subscribe to other recession indicators, such as yield curve inversions, real income, employment, industrial production, and retail sales. If you explore the first indicator, yield curve inversion, then you might be in the camp that a recession is coming. As you can see below, historically, a recession has followed a yield curve inversion 80% of the time.
U.S. Treasury Curve Inversions – January 1, 1962 – July 31, 2022
Sources: FRED, NBER (for economic recession data)
Since January 1962, there have been ten periods of yield curve inversion. In eight of those periods, the inversion was followed by an economic recession within 13.6 months, on average.
|Yield Curve Inversion Date||Months to Recession|
|April 11, 1968||19 months|
|March 9, 1973||7 months|
|August 18, 1978||16 months|
|September 12, 1980||9 months
|December 13, 1988||18 months|
|February 2, 2000||12 months|
|December 27, 2005||23 months|
|August 27, 2019||5 months|
Sources: FRED, NBER (for economic recession data)
The most recent yield curve inversions happened on April 1, 2022, and again in July of this year. Also, the yield curve inversion between 10-year and 2-year rates reached its largest point since 2000 on July 12. Does that mean a recession is imminent? That remains to be seen.
Another common recession indicator is retail sales. Several big retailers have recently reported high inventory levels and lower demand. As a result, a few retailers have announced downward revisions to margin forecasts for the second quarter of 2022. This indicates consumers are being careful with their spending and spending less. It also means these retailers are under pressure to reduce their current inventory, potentially at deep discounts, to make space for the upcoming holiday season inventory.
However, in discord to the negative indicators, employment remains strong. In June, non-farm payroll employment rose, while the unemployment rate remained unchanged at historically low levels, according to the U.S. Bureau of Labor Statistics. This makes the current environment unique. In the past, each time the market has gone into a recession, unemployment has risen substantially, as GDP decreased. As we stand now, this is not the case, making the current environment appear different.
Preparation is Key
Whether the indicators point to a recession or not, the key to market uncertainty is always being prepared—in good times and bad. This means proper diversification should be a constant mindset, not a reaction. Investors must look for other sources of return that can provide diversification beyond stocks and bonds.
Managed Futures is one such strategy. Known for its low correlation to nearly all asset classes, differentiated return stream, and ability to provide crisis alpha, Managed Futures are a worthy alternative to fixed income. These strategies have shown strong historical performance when stocks have suffered, especially in recessionary periods.
Another option to consider is to blend different strategies that are uncorrelated to stocks and bonds. Diversifying a portfolio with these strategies has the potential to both mitigate risk and improve long-term returns. By combining low-correlating strategies, this sleeve of the portfolio can deliver a more consistent return stream and provide a smoother ride across multiple market cycles—including uncertain ones—creating an investor experience with better outcomes and less volatility.
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