May 9, 2022
Since the beginning of the year the markets have been rattled by persistently high inflation, and an even more persistent question of how the Federal Reserve might respond.
Consistently high inflation is a destructive process for savers as well as workers. It is so problematic that the Fed has said that maintaining a consistent level of inflation is one of their core mandate's.
One of the tools that the Fed will employ in fighting inflation is to raise interest rates. In March, the Fed began with a simple 25 bp (bp = basis points, 1 bp = 0.01%) rate hike in the fed funds rate to 0.25%-0.50%. Unlike the rate-hike cycle of the 2000s and the very gradual increases in the 2010s, inflation is a big problem today.
We are seeing comments from key Fed officials that “it is of paramount (my emphasis) importance to get inflation down" (Wall Street Journal, April 5, 2022) and Today’s high inflation “is as harmful as not having a job…. If you don’t have the confidence [the Fed will use its inflation-fighting tools], let me give it to you" (CNBC, April 5, 2022).
Based on these comments, we should not expect the baby steps, so small and slow rate increases, that we have grown accustomed to in the past.
This is your father’s rate-hike cycle
An aggressive tightening cycle can generate volatility in two ways.
First, higher interest rates compete more effectively for an investor’s dollar, siphoning cash away from stocks. Second, higher interest rates can slow economic growth, which may put the brakes on profit growth.
In addition to higher interest rates, the Fed is set to let the bonds it purchased in 2020 and 2021 runoff its balance sheet in a measured fashion. In other words, investors are not only grappling with higher interest rates, the runoff in bonds may create additional obstacles.
Performance bears this out. The S&P 500 Index is off to its worst year-to-date start since 1939, according to Dow Jones Market Data (WSJ).
Table 1: Key Index Returns
||MTD %||YTD %|
|Dow Jones Industrial Average||-4.9||-9.3|
|S&P 500 Index||-8.8||-13.3|
|Russell 2000 Index||-10.0||-17.0|
|MSCI World ex-USA*||-6.9||-12.0|
|MSCI Emerging Markets*||-5.8||-12.7|
|Bloomberg US Agg Bond TR USD||-3.8||-9.5|
Source: Wall Street Journal, MSCI.com, MarketWatch, Morningstar
MTD returns: Mar 31, 2022-Apr 29, 2022
YTD returns: Dec 31, 2021-Apr 29, 2022
*In US dollars
Fears are rising that the Fed’s new-found inflation-fighting backbone might choke off economic growth. Should we be concerned?
GDP unexpectedly contracted in Q1 at an annualized pace of 1.4%, according to the U.S. BEA. But the decline was related to one-off factors.
During Q4 2021, GDP surged 6.9%—also due to technical factors. We believe it’s better to average the last two quarters. Besides, an acceleration in consumer and business spending during Q1 was encouraging.
Here are a few other encouraging stats.
An astonishing 1.7 million jobs were created in the first three months of the year, per the U.S. BLS.
First-time claims for unemployment insurance are hovering near the record low set in the late 1960s—records date back to 1967 (Department of Labor). Further, business openings are at a record high (U.S. BLS), in part because business activity has been strong.
We wouldn’t be seeing these numbers if the economy were contracting.
Let’s look at some of the anecdotal evidence. If the economy is weak, consumers shy away from discretionary purchases. When it comes to travel and entertainment, that’s not happening.
Here’s an interesting remark from the CEO of McDonald’s, who said the consumer is in “good shape” because customers are still ordering items for delivery, the most expensive way to buy due to the hefty convenience fees (CNBC).
Put another way, we complain about inflation, but we complain while in line to make a purchase.
Still, stimulus money stashed in savings accounts may be aiding overall spending, which may be artificially supporting growth. Per U.S. BEA data, incomes are not keeping up with inflation, which could eventually create resistance to higher prices just as the Fed is lifting rates and raising the cost of money.
What will it take to stabilize the market?
High inflation, worries about the Fed, slowing global growth, and the ongoing war in Ukraine are well known. The pullback in stocks reflects the high level of negative sentiment, and at least in part, stiff headwinds are already priced in.
Are we at or near a bottom? We don’t try to call bottoms or tops, and that articulate analyst on the financial news network may be smart, but they don't have a crystal ball.
Here are some thoughts about various possibilities.
If Russia were to suddenly end its hostilities in Ukraine, a significant short-term headwind would be eliminated. Sadly, this best-case scenario, which would end the needless suffering in Ukraine, is highly unlikely.
More realistically, investors want signs that inflation is not only peaking but on a downward path. Why? It would reduce the need for steep rate hikes.
Powell and the Fed are hoping to slow inflation without tipping the economy into a recession. But they will need skill and some luck.
For starters, the dollar is flexing its muscle on foreign exchanges. A strong dollar may reduce import price inflation. But the Fed will need more help from the supply chain, which has been slow in coming. Today, new Covid lockdowns in China are exacerbating problems.
We do not believe investors should be taking outsized risks. Successful investors are disciplined. They refuse to let excess optimism or pessimism guide their decisions.
It is time to employ a disciplined approach and maintain recommended asset allocations. Just as these ‘guardrails’ can keep you from lurching into riskier assets when stocks are quickly rising (and we feel invincible), the parameters are also in place to prevent emotion-based decisions that can sidetrack you from your long-term goals.
If markets continue to slip shorter-term, rebalancing helps add to your positions when stocks are down, i.e., buying low.
If you have questions or would like to talk, we are only an email or phone call away.
As always, thank you for the trust, confidence, and the opportunity to serve as your financial advisor.
May 9, 2022