Stormy September Strikes Again

Stormy September Strikes Again
Russell Burns

over 1 year ago4 mins

  • The Fed’s balance sheet is shrinking, and that’s pushing asset prices to slip.

  • Even if the Fed stops or pauses rate hikes, it may be too late to avoid a recession.

  • If you think interest rates have peaked, preferred shares could be a good bet for steady income and potential capital gains

The Fed’s balance sheet is shrinking, and that’s pushing asset prices to slip.

Even if the Fed stops or pauses rate hikes, it may be too late to avoid a recession.

If you think interest rates have peaked, preferred shares could be a good bet for steady income and potential capital gains

Mentioned in story

Stormy September doubled down on its reputation as the worst-performing month of the year: the S&P 500 Index fell 9.3% during the dreaded month, and the Nasdaq 10.5%. And it turns out the Federal Reserve (the Fed) – busy powering up interest rates and slimming down its balance sheet – could be behind the selloff.

How long can this trend continue?

There might be some clues in the Fed’s balance sheet. See, legendary investor Jeremy Grantham’s GMO – manager of more than $100 billion of assets – highlighted a risk for assets if the Fed’s balance sheet shrinks. And GMO isn’t the only one to have noticed this link: multiple studies have shown that markets react positively to expansions – and negatively to contractions – of the Fed’s balance sheet with a time lag of around a few weeks.

Fed Balance Sheet and the SPX 500 Index. Source: Bloomberg
Fed Balance Sheet and the SPX 500 Index. Source: Bloomberg

Check it out for yourself: the chart shows the size of the Fed’s balance sheet (white line) and the S&P 500 Index (blue line). You might be able to pick out the S&P’s virtual freefall when the pandemic went viral in March 2020. Well, it rebounded pretty well soon after the Fed announced it would ease its monetary policy, which means bulking its balance sheet and trickling more money into the financial system – and that’s despite much of the world’s economy going into a virtual lockdown.

But what goes up must come down. The Fed’s balance sheet increased from $4.3 trillion to $8.9 trillion during the pandemic, as the central bank fought to keep interest rates low by buying a huge number of bonds. Now, though, the Fed’s slowly slimming its balance sheet via “roll off”– basically, not buying new bonds when the ones it holds mature – as part of its plan to bring inflation back to its medium-term target of 2%. And while it started slowly with a $45 billion reduction per month in June, July, and August, it ramped that up to a whopping $90 billion per month from September. This slimdown might last a while too, with the Federal Reserve Bank of New York projecting back in May that the Fed’s balance sheet would drop to $5.9 trillion in 2025. There is a caveat here: whether or not that happens will massively depend on how the economy performs in the meantime. But as you can see in the chart above, a $5.9 trillion balance sheet lines up with an S&P level of around 3,200 – around 10% lower than its current level.

Total Assets of Major Central Banks. Source: Yardeni, Haver Analytics
Total Assets of Major Central Banks. Source: Yardeni, Haver Analytics

Mind you, it’s not just the Fed. All of the major central banks have followed this same mantra in the last few years: increasing their balance sheets, buying bonds, keeping interest rates low, and buoying up asset prices. And all that balance sheet bulking – which has been underway since 2020 – is now being undone as higher inflation takes its toll. After all, inflation-fighting tactics like higher interest rates and tighter monetary control are putting mounting pressure on global asset prices, making them a less attractive investment opportunity for retail investors too. And there might be no going back: Morgan Stanley strategist Michael Wilson recently claimed that even if the Fed stops hiking rates, it may well be too late to save markets from staying lower for longer. Case in point: Wilson sees the S&P 500 dropping 10% to 20% lower than its current level by later this year or early next, and superbearish Jeremy Grantham also believes it could drop 20% next year.

What is the opportunity?

One investment starts looking like a tempting bargain after interest rates have risen: preferred shares, which end up going for less. But since they have fixed dividends (think of a bond, but with bigger coupons), their yields increase as their payouts remain stable. Preferred shares don’t give their owners voting rights like common shares do, but their holders rank higher than equity investors if a company liquidates and its assets are distributed. They could make for a solid investment if you’re searching for a stable income, and if you believe interest rates could be close to peaking. See, if interest rates start to decline, your shares will increase in value, meaning you’ll pocket a pretty capital gain as well as your dividend. If interest rates remain stable, your preferred shares will likely hover around the same price you paid, but at least you’ll still receive a dividend.

If you are in the market for preferred shares, you can find a pretty comprehensive list of them here. Plus, you can find Goldman Sachs’s (GS) and JP Morgan’s (JPM) preferred shares yielding more than 5%. If you’d rather steer clear of individual ones, the Invesco Preferred ETF (ticker: PGF, expense ratio: 0.61%) is paying a yield of around 5.6%. And if you think Grantham is on the money about the S&P’s potential fall, you might want to check out some of these bearish trade ideas.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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