The Financial Advocate: Summer 2022
Changing Their Tune: Policy Makers and Persistent Inflation
Evoking the Strange Case of Dr. Jekyll and Mr. Hyde, we are confronting a famous psychological thriller through the actions and attitudes of Federal Reserve Chairman Jerome Powell. As recently a few months ago, the Chairman was still engaged in quantitative easing (injecting liquidity into the market with the goal of stimulating the economy), while proclaiming that inflation was “transitory.” Today, the Federal Reserve is headed in exactly the opposite direction: extreme tightening of the economy through higher interest rates, draining liquidity, and proclaiming that inflation is becoming “entrenched.” Wow! Same guy, a short time later, and a very different story! The effects on the investment markets and the economy have been staggering.
Here are some of the facts of the first half of 2022:
- This is the worst start to a year for the markets since 1970. 52 years ago! The S&P fell more than -20% at one point. The NASDAQ had fallen in excess of -28%. In eleven of twelve weeks in the second quarter, stock market index returns were negative.
- Crypto currencies, as measured by Bitcoin, retreated approximately -72%.
- Mortgage rates doubled from the mid 3% range to approximately 6%. (These rates are moving extremely quickly, largely following the trajectory of the 10-year Treasury). National new home inventory has gone from a 4-month supply to a 9-month supply.
- GDP contracted in both the first and second quarters
- Consumer and business confidence levels are flagging. Real income, adjusted for inflation, is falling. There is some concern that this could lead to a wage/price spiral not seen since the 70’s.
- We cannot ignore the tragic war in Ukraine and its impact on the lives of the Ukrainian people. This war is also causing havoc in both the food and energy markets, especially in Africa and Europe.
Just a few months ago, many Wall Street strategists were calling for new record highs in the indices … this year! We believe that outcome is unlikely at this point. However, a positive that we can identify is when markets behave this poorly in the first half of the year, they tend, on average, to move higher in the second half of the year. Historically, they do not erase all the losses from the first half, but they have pared them.
The Fed, Inflation, and the Economy
Federal Reserve Policy and Inflation
What is going on with monetary policy?
We believe that the Federal Reserve found itself behind the curve this year. The inflation shocks caused by a reopening economy have persisted beyond the “transitory” period espoused by many policymakers. There is little debate that they should have ended liquidity injections long ago (arguably last fall at the latest). The first law of economics is that the economy is governed by supply and demand. Balancing supply and demand helps keep inflation in check. Events like supply shocks have the nasty effect of increasing inflation. Today, supply shocks are all around. The three most clearly identifiable shocks are in the food, energy, and labor markets. The Fed has no direct control over the supply of these factors. So, to cool inflation, they move to the other side of the equation – demand. Here, by making the cost of everything more expensive through interest rate policy and monetary tightening, they achieve “demand destruction.” By reducing demand through higher interest rates, inflation will ultimately subside. Investors have a legitimate concern that this process could stall the economy, causing a recession. We are in the middle of this process; only time will tell if the Federal Reserve’s approach can cool the economy without freezing it.
There are signs of an initial slowdown in the inflation rate and we believe there is a good chance we are past “peak” inflation. This is good news. A key indicator of this is cooling commodity prices. Prices of many base commodities are falling – lumber, steel, copper, and some foods. All have trended lower in recent weeks. We expect the CPI, PPI, and PCE figures to remain focal points for investors for some time. The “sticky” parts of the inflation situation appear to be energy and labor costs.
Energy markets have a history of major price swings driven by geopolitical events. Unfortunately for consumers across the globe, that history repeated itself in 2022. Exogenous shocks make it difficult for even the most seasoned analyst to predict energy prices. Arguably, the war in Ukraine has added a $20 to $30 premium on a barrel of oil. The energy sector is the only positively performing sector this year. It should be noted though that even if the war in Ukraine were to end and oil markets came back into equilibrium ($75-$80 a barrel), most US oil companies would still be strongly profitable. At VWM we believe in a cleaner, healthier environment and that the shift away from fossil fuels is necessary. However, an overnight shift to renewable resources is not possible. This is a multi-decade process. Our investment approach is to focus on the best operators in the fossil fuel business, with the best record of ESG principles, while continuing to seek rewarding investments in solar, wind, and other alternatives.
The Labor Force and the Health of the Consumer
Analysis of the consumer is challenging at this juncture. So far, the consumer has been feeling the weight of inflation but has not buckled. Accounting for approximately 70% of domestic economic activity, how the consumer responds to high inflation is critical to the overall health of the US economy. The unemployment rate is arguably too healthy at less than 4%. Spending has been pretty good while wages are beginning to lose ground relative to inflation. This is taking a toll. Tellingly, consumer credit levels are rising while savings accumulated during the pandemic have been receding. Having been suppressed during COVID, certain portions of the services economy are springing back to life. Consumers are buying plane tickets, vacations, hotel rooms, and cruises with abandon! However, they are taking on debt to do it. That won’t last forever.
If unemployment remains relatively low during a potential recession, the consumer can help lift the economy out of recession more quickly than if unemployment was high and entrenched. At VWM, our approach is to monitor the labor markets for signs of softening while pursuing investments in robotics and other workplace efficiencies. A simple example is that the “dirty job” of working the fry baskets at fast food restaurants is gradually being replaced by industrial robots. This type of automation will surely continue across multiple sectors of the economy. Hopefully, labor markets will cool in the months to come. This is a scenario where the “bad news” of rising unemployment may be treated as “good news” by investors and economists alike.
Economist’s Corner by Roger Klein, PhD
The newspaper headlines (yes, there are still newspapers) tell us that this is one of the worst performances over a six-month period and the worst initial start since 1970 when Richard Nixon was president. There is nothing magical about the first six months of the year and poor performance over a six-month period, or any time, tells us nothing about future performance. For example, Jeff DeMaso, writing in The Independent Adviser for Vanguard Investors, looked at the record book. There were 13 six-month periods since the inception of the S&P 500 index in 1957 when the index fell by 20% or more. These were difficult times for investors, but in all cases these market declines were followed by powerful rebounds.
On average, the S&P 500 index gained 17.6% in the six-month period following a 20% or worse six-month stretch. The index was lower on only one occasion and over the following 12 months, the S&P 500 was higher every single time with an average gain of 28.2%.
Past results are no guarantee of future outcomes. Nobody knows how far this bear market will fall. In the past 100 years there have been 18 bear markets, or one about every 4-6 years on average. Of those bear markets, one-third have been “major” bear markets, with losses exceeding 40%. The current peak-to-trough price decline in the S&P 500 is 24.53%. Nobody knows the future and it is important not to underestimate the downside risk in a bear market. “Major” bear markets are associated with severe economic recessions and at this time the jury is still out on whether we will experience a recession. The good news is that even in a ”major” bear market, current losses reflect that perhaps half or more of the final damage is behind us.
Identifying when a final bottom is in place will not be easy. Bear market bottoms are often V-shaped events, with a sharp sell-off followed by a strong rebound. Nonetheless, there are identifiable characteristics and none of them are present at this time. For now, it is important to remain patient and disciplined.
This quarter’s financial planning topic is “asset allocation review.” Many of our clients have held-away retirement accounts, separate investment accounts, private holdings, etc. In periods of high volatility, it is important to review these holdings as part of your comprehensive financial plan. We are happy to aggregate these assets to help you gain a better understanding of how different holdings are performing in relation to one another, and to determine if there are assets that may be creating a disproportionate amount of risk to your overall portfolio.
Your Retirement Plan
We are happy to assist with financial planning advice, help make investment selections, and discuss your investment portfolio. Please reach out to Dan McElwee at 609-671-9100 or firstname.lastname@example.org for any of these matters.
Nick Ventura, CFP® CPWA®
President / CEO