As a portfolio manager (PM), the basics of my job involve doing a client discovery (which usually involves a financial plan) to understand a client’s situation (partly to help me create investment objectives and risk tolerances for the client), in order to then develop a strategic asset allocation model that highlights, among other things, how much of a client’s money should be allotted to cash, fixed income and equities over a long term basis. Assuming the client is open and honest during discovery and my assessment of the client’s situation is accurate, the process of “marrying” the client to a product and service is, for the most part, an objective exercise that is pretty straightforward. As a PM, the more challenging part of my job and the more subjective part is to understand financial markets in the shorter and intermediate term to “fine tune” a client’s asset allocation, with the goal of making their investment portfolio a little more defensive as we head into more challenging economic times and a little more offensive as we head into more robust economic times. Of course, there are many more aspects to my role as a wealth advisor that complement my role as a PM, but I’ll leave that discussion for another time!
When deciding on my short-term asset allocations for clients, as a PM, It’s not my job per se to do primary research to develop an outlook on the economy or financial markets.
I leave that up to economists, investment strategists, research analysts, and the like. My role, rather, is to listen, understand and decide on who I believe has it right with respect to the outlook on economies, financial markets, and individual securities in the investment world and then to apply those outlooks/forecasts to my clients’ investment portfolios accordingly – again, on a tactical basis. So, now that we have the disclosures out of the way … let’s talk!
Given everything I have said above, I thought today I would give my own original thoughts and opinions on interest rates for the purposes of hopefully generating some discussion on the topic. A couple of weeks back, I actually listened to the live news conference and Q and A session that followed, by Chairman Jerome Powell of the U.S. Federal Reserve (the Fed). I know what you’re thinking… wouldn’t he have more fun watching paint dry! In fact, I found the meeting very interesting! But don’t judge my personality just on that last comment …I’m also very interested in gardening, travel, visual arts and performing arts.
So here’s what my ears heard and my brain processed from the Fed meeting last week. During Powell’s prepared remarks he made it clear that the pace at which rates continue to rise (the how fast question) will begin to moderate. That is to say, going forward, it’s not that they are done raising rates, but the Fed will do so in a more gradual manner than what we’ve seen in the past since when they began raising rates during this current cycle. This means, instead of raising rates by 75 basis points in future meetings, the Fed hopes to raise rates by only 50 basis points and then possibly 25 basis points thereafter, until it stops raising them altogether at some point in 2023. I also think in the prepared remarks by the chairman, he made it clear that the committee of Fed officials that votes on interest rate policy, has a preferred policy path on rates, namely, it will try not to raise rates too much more, suggesting they will be patient with trying to get the inflation Genie back in the bottle. (This answers the how high question and dovetails into the final question of how long).
In turn, the last statement suggests rates will have to stay elevated for a longer period of time than is normally the case, given future leading economic indicators may suggest the time has come to lower rates at some point in 2023. This may mean the Fed may wait for lagging indicators (inflation itself being a lagging indicator) that show the cost of living is trending back down to its preferred 2 per cent target and that inflation has indeed fallen and will continue to do so over the long run.
The combination of these three answers to the interest rates questions I have posed above suggests the Fed raised rates very aggressively to play catch up as they were late in starting to fight inflation, and from here, the committee is content to raise rates more gradually, to see what happens to inflation and the economy (the so-called data-dependent approach). From there, they may very well keep them at the moderately higher level, but for much longer than the current consensus, to ensure inflation has in fact been beaten.
This means victory in lowering inflation for the Fed may take longer to achieve, however, there should be less collateral damage than would otherwise have occurred, if they had tried to beat inflation with a much more aggressive campaign of raising rates much higher but for a shorter period of time.
Think of it in these terms:
A doctor has a sick patient and chooses as a first option, to administer medicine at a lower than otherwise generally recommended dose, but for a longer period of time to cure the patient, (given the patient’s specific situation). By doing so, the doctor is hoping to minimize the negative side effects that the patient may encounter with the much higher generally recommended dose. Taking this path highlights the doctor’s hopes to cure the patient with the lower dose administered over a longer period of time and at the same time having cured the patient without having the patient experience the potential negative side effects of the higher dose the patient may have endured had the higher generally recommended dose be given.
So I would suggest that interest rates will go marginally higher from here, but then stay there for longer than the consensus expectation. This means that ultimately inflation will be beaten, but over a longer period of time than market participants think, so as to avoid or lessen a lot of the negative economic collateral damage that would occur if rates rose more aggressively over a shorter period of time. This means I believe the Fed is anxious to get to 4 per cent from where inflation stands today but will be more patient to get to its stated target of 2 per cent over the long term in a more gradual manner.
Mike Candeloro, Senior Portfolio Manager and Wealth Advisor with RBC Dominion Securities and the head of The Mike Candeloro Wealth Management Group supplied this article. RBC Dominion Securities Inc. and Royal Bank of Canada are separate corporate entities, which are affiliated. Member CIPF. Mike can be reached at [email protected] or on his LinkedIn page. You can also visit his website at www.michaelcandeloro.com