Markets were mostly negative for the month of August as investors received something of a reality check from Fed Chair Jerome Powell. The S&P 500 finished with a 4.08% loss despite gaining 17.68% from the year’s low on June 17 through August 16. Growth style equity indexes took the brunt of the pain in August, with the S&P 500 Growth losing 5.3% compared with the S&P 500 Value losing only 2.8%. International stocks were mixed with the developed market index, the MSCI EAFE, losing 4.7% while the MSCI Emerging Market index was slightly positive at 0.46%. The bond market gave back much of its recent gains, with the Bloomberg Aggregate losing 2.8% in August; this was driven by interest rates ticking higher across the yield curve. The U.S. 10 Year Treasury yield rose from 2.64% at the end of July to 3.15% by the end of August.

The main story driving the market in August was undoubtedly the anticipation of, and reaction to, Fed Chair Jerome Powell’s speech on August 26^th at the annual central bank symposium in Jackson Hole, WY. Even though Powell has spoken publicly almost every month this year, the media tends to add extra weight to comments made by Fed Chairs at the Jackson Hole event. While markets began to lose steam about 10 days before Powell’s speech due to uncertainty, Powell’s decidedly hawkish tone sent stocks lower and rates higher from August 26^th through the end of the month. The entire eight-minute speech was hawkish, but the following quotes provide a good encapsulation of the message:

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation.”

And this quote, referring to former Fed Chair Paul Volcker’s battle with inflation in the 80s:

“A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year…We will keep at it until we are confident the job is done.”

In summary, the Fed is willing to inflict economic pain to get inflation under control, and they aren’t anywhere close to feeling like that job has been accomplished. The speech stands in stark contrast to Powell’s last press conference, in which he signaled a softer perspective by saying:

“As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.”

It can be easy to get wrapped up in analyzing every word made by the Fed Chair. The Fed is the most important institution to financial markets in the U.S. and arguably even globally, for better or worse, and investors are wise to heed signals put out by its current leader. However, as we’ve pointed out multiple times before, Jerome Powell is facing the same set of uncertainties that the rest of us are—namely, how long and severe will inflation be, and how much of an impact higher prices and interest rates will have on the labor market and the economy. The way these questions pan out will dictate the course of the Fed; this is what they mean by data-dependent decisions. Stepping back and evaluating how markets have behaved this summer, June 17 through August 16 saw a massive rebound in stocks and bonds along with steep decline in longer term yields. The U.S. 10 Year Treasury yield fell from 3.49% in mid-June to 2.56% in August. The narrative driving this can be summed up as, “Sure, the Fed will hike rates a bit more this year, but we all expect that they’ll be in rate-cutting mode by some point in 2023 as the economy softened.” Powell’s speech in Jackson Hole threw a big wrench in that narrative by suggesting the Fed is willing to inflict more economic pain than previously thought. The monthly Job Opening and Labor Turnover Survey (JOLTS) released on August 30 showed an incredible 11.24 million job openings in the U.S., more than double the current number of job seekers. Such a tight labor market suggests that the Fed has plenty of leeway to hike rates before unemployment becomes enough of a concern to stop hiking.

By anticipating the future actions of the Fed, capital markets often do the Fed’s job for it by adjusting interest rates higher and asset valuations lower before the Fed ever lifts a finger. The Fed was probably grateful for this through the first half of the year, as interest rates had already climbed steeply by the time the Fed announced the first rate hike in March. By the same token, Powell may have been frustrated this summer as capital markets began to anticipate a softer line on inflation than he may have intended. Powell’s Jackson Hole speech was short and blunt, suggesting that he wanted to set the record straight and leave little room for misinterpretation.

The jobs report on September 2, the inflation readings of CPI and PCE on September 13 and September 29, respectively, and the Fed’s next interest rate decision on September 21 will be the focal points for the market over the next month. In addition to this, with the upcoming midterm elections on November 8, we expect that heightened uncertainty will amplify volatility this Fall. Investors would do well to remember that neither Republicans nor Democrats see resoundingly better market returns during different eras of political control, and in fact the historical record shows that markets often perform the best during stretches of divided government. The general consensus among polling analysts as of the end of August is that while the Republicans are strongly favored to take the House of Representatives, the Senate has become more of a toss-up in recent weeks, potentially even leaning toward the Democrats retaining control. Whatever happens in the Senate, the most likely outcome appears to be a divided government with a Democrat President and Republican House. Even though neither party has been significantly better from a historical market return perspective, the lead up to elections can often be volatile for stocks and bonds as investors face the uncertainty of what the next two or four years will look like.

The second half of August was a strong reminder that investors aren’t out of the woods yet. Success will come to those who remain focused on their long term goals and avoid getting too hung up on the week to week drama that has characterized 2022.

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