- Stocks plummeted after the Federal Reserve hiked interest rates, although the move was telegraphed.
- Allianz Investment Management’s Johan Grahn shared why there won’t be a soft landing for the economy.
- This allows investors to manage risk and limit volatility when the likelihood of a recession increases.
The Federal Reserve’s decision to raise interest rates by 75 basis points in September to stem high inflation came as no surprise. Or, in the words of Johan Grahn, head of ETF strategy at $19.5 billion Allianz Investment Management, it was “not necessarily earth-shattering.”
But the move could end up rocking an already fragile economy.
“There is no doubt that they need to stall the economy,” Grahn said of the Federal Reserve in an interview with Insider on Wednesday afternoon. “And I think that’s clear to most.”
Investors appear to agree with Grahn’s bearish sentiment. The S&P 500 went into freefall right after the Fed’s announcement on Wednesday, but then shot up 2% only to give up those gains and end the day down 1.7%. The strong selling continued on Thursday.
Any hopes that inflation will fall of its own accord without drastic action from the Fed have faded.
“You’ve re-set the bar for expectations,” Grahn said. “So if anyone ever thought, ‘Well, maybe a pivot is coming down the pike here,’ they’ve effectively eliminated that type of speculation for at least the next 12 months.”
Fed Chair Jerome Powell, who in the past has done everything in his power to be optimistic, has acknowledged that bringing inflation down will be painful. The consequences of higher interest rates include lower corporate earnings and stock valuations, slower growth and a higher unemployment rate.
“They’re trying to calm things down and, frankly, keep the economy and economic growth under control,” Grahn said. “And with that, you shouldn’t expect stock markets to go up. And when they do, it goes against what the Fed is trying to do.”
Sacrificing economic growth — even to the point where a recession occurs — is better than letting inflation run wild for years, Grahn said. That aligns with the “short-term pain for long-term gain” philosophy that Neil Azous, Rareview Capital’s founder and CIO, told Insider.
What is unclear is how much pain the Federal Reserve can endure. Harley Bassman, managing partner at Simplify, recently told Insider that a modest increase in unemployment is better than inflation, which continues to hurt tens of millions of Americans.
But hoping for higher unemployment at the expense of lower inflation could easily backfire, Grahn warned, as does the Federal Reserve’s plan to achieve higher inflation while lowering unemployment. In fact, Grahn said the U.S. jobless rate is more likely to jump from 3.5% to 5% to 8% rather than just rising to 4%.
Ultimately, according to Grahn, the Fed’s hyper-aggressive approach to tackling inflation for good can only end one way: a recession.
“I don’t think there’s a soft landing option,” Grahn said. “The records will show. But that aside, I think if you apply the logic of what the Fed is doing right now, if you’re using the kind of language they’re using, ‘at all costs’, ‘single focus’ mandate to bring down inflation,” – which is obviously the same as “bringing down the economy” – “trying to work until the job is done”. Those are the words they used.”
Grahn added, “The question is will it crash land sooner or later?”
How to invest when recession risk rises
Investors can manage risk in their portfolios if inflation stays hot and the economy weakens by employing a buffer strategy, Grahn said. This approach protects investors from losses of up to 10%, meaning a 20% drop would be a mere 10% hit. The catch is that the upside is also limited, meaning investors would lose gains in excess of 10%.
While this strategy isn’t for everyone, it can be an effective way to minimize volatility and downside risk if one is willing to give up the ability to maximize upside potential.
“It’s the idea of realizing what you’re willing to sacrifice,” Grahn said.
One way to use this strategy is to buy exchange-traded funds (ETFs) from companies like Allianz or Cboe Vest. But sophisticated investors can take a do-it-yourself approach, Grahn said.
By buying bearish put options and selling bullish call options in a collar, traders can capture limited upside potential while reducing their downside risk.
Investors tend to overestimate their ability to deal with volatility, Grahn said, adding that it’s wiser to make decisions ahead of time than to panic during major market swings. Before adopting this or any other strategy, the strategist said that investors must first define their risk.
“If you’re willing to sacrifice potential — if you think stock markets will be sluggish at best for ‘X’ number of years — you either have to just pull yourself together and say, ‘I’m fine with that, and I’m going to live by it for the rest of my life,” Grahn said. “But when you’re like, ‘Oof, it felt bad six months ago, it felt worse three months ago, now it feels really painful — me can’t take it anymore’, now you’re going to make a mistake. Now you’re too late.”