The stock market’s third quarter performance reminds us of the opening lines of A Tale of Two Cities. The first several weeks were “the best of times,” as stocks started the quarter on an up-note and appreciated meaningfully. The catalyst was the Fed’s late-June meeting, after which investors seemed to think the toughest and most aggressive part of the Fed’s fight against inflation was over. This optimistic sentiment gave way to “the worst of times” as investors turned pessimistic midway through the quarter. Inflation readings continued to be elevated and Fed Governors seemed to back away from achieving an economic soft-landing.
Instead, Fed Governors now seem willing to push the economy into a recession if that is required to reduce inflation. At the end of the quarter, the Fed raised short-term interest rates another 0.75% to levels last seen in 2008. Fixed income investments were also negatively impacted by inflation and interest rates during the quarter. In short, Wall Street’s adage – don’t fight the Fed – proved prescient.
In our opinion, investment returns will continue to be significantly impacted by the central bank’s interest rate policy for the foreseeable future. Interest rates have two primary impacts on investments. First, interest rates are the mechanism that investors use to discount future income streams. Higher interest rates reduce the present value of a future income stream, and as such, higher interest rates mean lower stock and bond prices. Second, higher interest rates make it harder for the economy to grow. Higher borrowing costs take funds away from growth opportunities, and money that was borrowed at low rates must either be replaced with higher cost loans or paid back. Both options take money out of the economy. Because stock and bond prices are determined in part by corporate earnings, the negative economic impact of higher interest rates will also likely negatively impact stock and bond prices.
The Fed’s determination to reduce inflation may drive stock and bond prices lower, and it may also weaken the economy in the short run. But over the long-term, their course of action will benefit the economy and investors because both will be much stronger in a low inflation world. Although 2022 has been a difficult year for investors, the outlook for future investment returns has improved. No one knows when the stock market will bottom, but bear markets set the stage for more attractive future returns. Lower prices and higher income yields sow the seeds for better long-term investment results.
Gamble Jones’ investment philosophy is based on the idea that owning companies with attractive returns on capital, healthy balance sheets, strong cash flow streams, good management teams, and attractive growth opportunities will generate attractive long-term returns, especially when the investments are purchased at attractive prices. Because your portfolio owns financially strong companies, the economic impact of higher interest rates should be relatively minimal for the companies you own. The portfolio’s companies do not need to borrow money to pay operating costs. Nor do they have high debt balances relative to their cash flows. Higher interest rates will not likely meaningfully reduce the cash flow that these companies can use to grow the business, pay dividends, or buy back stock. Additionally, an increasing number of high-quality businesses with long growth runways are selling at cheap valuations.
In conclusion, we would like to remined clients that it is wise to use volatile financial market periods such as these to review risk tolerance and investment goals. If you have any questions regarding these subjects, please contact us.