Jason P. Tank: Investors deal with slippery and messy conditions

Mar. 12—Investors are traveling through some messy conditions. After recent optimism about the Fed's progress on inflation, some doubts are creeping in. Emotional swings should be expected at this point in the cycle. For investors, this period calls for a higher degree of modesty than it does boldness.

To review, following the surge in inflation coming out of the pandemic, the Fed slowly woke up and then quickly started to raise interest rates. That process started almost exactly one year ago. To date, short-term rates have gone from 0% to 4.5%. The new consensus is for another 1% in hikes. That's certainly a lot for the economy to absorb.

But, interest rate hikes are a blunt tool that works on "long and variable lags." Their impact is back-loaded. It takes time for them to feed into the real economy. In contrast, the effect of interest rate hikes are front-loaded and immediately impact both stocks and bonds. The disconnect is often hard to reconcile for investors.

Let's put some numbers behind this disconnect. With the economy hanging in there throughout 2022, by October's low point stocks were down over 25% and bonds were off a whopping 15%. Since then, investors have clawed back almost half of their losses. With the future path of the economy still under intense debate, this level of market recovery can feel counterintuitive. But, remember, anticipated bad news is largely factored into financial markets. It always happens way ahead of reality.

And, it's also true that the more uncertainty surrounding the future, the more volatile the markets will behave today. Picture someone struggling to find their footing on slippery terrain. With inflation not yet vanquished and with the delayed impact of the Fed's massive rate hikes, for the past six months we've definitely been walking in some sloppy conditions.

Nobody is certain of how things will play out for the economy in the near term. On one hand, a very reliable indicator of a recession has been the presence of an "inverted yield curve;" that is, where short-term rates are higher than long-term rates. That signal is flashing bright red. On the other hand, despite the Fed's huge rate hikes, the jobs picture remains awfully strong with a large imbalance of two available jobs for each job seeker. It's a true conundrum.

I'm currently leaning on the side that the Fed will push on the brakes too hard and for too long. This is their typical mistake. But, most importantly, the depth and duration of a possible recession are much harder to predict. Naturally, future stock and bond market performance heavily depends on those two factors. Given the slippery and messy conditions, some continued level of conservatism is still wise.

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