High Level Commentary


CI Hi Level 220617

Inflation, the Fed and Potential Recession:

The Federal Reserve has raised short interest rates by 1.5% so far in 2022 and they expect to raise rates another 0.75% at their next FOMC meeting on July 27.   They expect to continue to raise rates until there is a meaningful reduction in inflation.  At this point, the Fed Funds rate is expected to peak at around 3.75% by year-end 2023.  The Fed will also allow a faster roll-off of their $9 Trillion holdings at the U.S. Treasury.  Taken together, these actions demonstrate a significant commitment to reducing inflation.  Most market observers believe the Fed was too slow in recognizing persistent inflationary pressures, and there is now a fear that rate increases will cause a recession.  A Wall Street Journal poll shows that 44% of economists expect a recession within the next 12 months.  Moreover, a Conference Board survey shows that more than 60% of corporate CEOs expect a recession in the next 12 to 18 months.

Russian invasion of Ukraine:

The immediate impact has been the loss of life and devastation of civilian targets.  In addition, rising energy and food prices are curtailing economic growth, threatening regional food supplies and increasing recession risks.

Russia ranks as the 11th largest country in the world, but Russia produces 10% of the world’s oil and over 25% of global palladium.  Russian accounts for nearly half of EU natural gas imports and almost a quarter of oil imports. 

Russia and Ukraine account for nearly 30% of global wheat exports, one-fifth of the corn trade and 80% of sunflower oil production according to the USDA.  Prices have skyrocketed and raised concerns about food security, especially in the Middle East and North Africa.

Global economic growth will also be negatively impacted.  UBS Economists estimate that for every 10% increase in prices of fuels, gas and electricity, consumer-spending growth in the eurozone slows by 0.4 of a percentage point, and economic growth by 0.2 of a percentage point.

Geopolitical risks have been highlighted as the security structure in place since the end of WWII has unraveled.  Before the invasion of Ukraine, Putin sought closer relations with Xi Jinping, as was evidenced by their joint appearance at the Winter Olympics in Beijing.  China is concerning because it continues to see Taiwan is a breakaway region.  Finally, Iran continues their nuclear development capabilities.  The unified global response and sanctions against Putin and Russia, however, has cast a very negative image of military aggression by Russia, China or Iran.   

Short-Term Positive:

The U.S. economy declined -1.5% in 2022 Q1, but the drop was due to larger imports (U.S. demand being met by other countries’ production), and by lower inventories.  Consumer spending actually increased at a 3.1% annual rate, and business investment increased at a 9.2% annualized rate.  Consensus forecasts for calendar year 2022 are being revised down but remain positive at a rate of 1% to 2% growth.

Corporate earnings surprised to the upside during 2021 and remained positive during the 1st quarter 2022 reporting season.  According to FactSet, S&P 500 earnings in 2022 Q1 increased 9.1% and revenue grew 13.4%.  Earnings are expected to increase at a respectable 10.4% in 2022 and revenue growth is expected to increase 10.7%.  Earnings growth is seen at 9.8% for 2023 and revenue is expected to grow 4.9%.  Although expectations remain favorable, inflationary pressures hurt Walmart, Target and other retailers.  If inflation remains higher than expected, then broad-based consensus earnings growth could be revised downward. 

Retail sales have been strong.  Retail sales have been strong based on a strong labor market, but sales did decline -.3% in May.  Retail sales are up 8.3% on a nominal annual basis.

Geopolitical risks.  Although wars are tragic, history shows that the market generally has positive performance a year after hostilities begin.

The $1 trillion infrastructure package passed with bipartisan support, and economists believe that this spending has the potential to increase economic growth and productivity.  Growth and productivity gains will be modest, however, since the funds will be spent over a number of years.  The proposed $1.75 trillion “human infrastructure” Build Back Better reconciliation bill has been sidelined as politicians focus on the upcoming mid-term elections. 

Some of the stimulus dollars moved into the markets.  This provided short-term investment demand to push prices higher.  Although there are no more stimulus payments, there continues to be significant retail “cash on the sidelines” that can help stabilize the market. 

The Omicron variant and other sub-variants have not caused another spike in hospitalizations or deaths, allowing the global economy to begin move towards more normal economic activity.  Hopefully there will not be another highly transmissible variant.  There have been over 5 million coronavirus deaths globally and over 1 million deaths in the U.S.  There is growing recognition and acceptance that COVID will remain as an endemic.   

Short-Term Negative:

The U.S. stock market and the bond market are off to a negative start in 2022, with all major asset categories down on a year-to-date basis.  The geopolitical developments related to Ukraine and Russia are obviously a major concern, but the market is also wrestling with how far and how fast will the Federal Reserve will push up interest rates to reduce inflation.

-Recession risks are rising.  The S&P 500 has dropped over 20% into a so-called  bear market since the January 3 peak.  There have been 17 bear markets since World War II and the average decline has been -31%.  Of the 17 bear markets, 9 were accompanied by a recession, and the average recessionary decline was -36%.

Consumer inflation is increasingly reflected in current data as the May headline Consumer Price Index shot up 8.6% over the last 12 months, a level not seen since December 1981.  The core CPI, net the volatile food and energy sectors, was up 6.0%.  Federal Reserve officials previously said that inflation was “transitory” due to supply chain problems, but inflation has broadened into wages, and this raises the potential for a wage price spiral.  History shows that inflation is hard to contain after it has gained momentum.  The market is very concerned that inflation may prove to be more than transitory. 

The $1.9 trillion government stimulus package passed back in March 2021 helped economic growth exceed expectations in 2021, but it now appears that last year’s stimulus is fueling current inflation.  Forecasts for 2022 are now being revised downward on current inflation fears, but growth should remain positive in 2022.

Powell Pivot:  Fed Chair Jerome Powell, acknowledged last November that inflation had become more concerning, that it’s “probably a good time to retire that word (transitory) and try to explain more clearly what we mean.”  The Fed previously maintained that inflation was “transitory”, but it now recognizes that inflation may persist longer than expected.  As a result, the Fed an acceleration of their timeline for phasing out their $120 billion monthly purchases of treasury and mortgage bonds.  This policy was formally announced at the December 15 Federal Open Market Committee meeting. 

As these developments push up interest rates, they provide a headwind for long-maturity bonds and stocks.

Geopolitical:  The Ukraine/Russia conflict is a clear negative development.  The market previously dismissed this risk, but the invasion forced up energy and other commodity prices, and the broader impact is clearly negative.

President Biden’s Build Back Better legislation is currently on hold as discussion continues on a scaled-down plan.  With posturing for the mid-term elections already in progress, it is difficult to know what legislation might be passed.

The so-called Fed Put gave investors a measure of downside support for the markets over the last decade.  (In the options market, a “Put” position increases in value when markets decline and thus provides an upside offset or hedge against market drops.)  Although there was no actual market “Put”, the Federal Reserve purchased massive quantities of bonds and kept interest rates abnormally low to support the economy and the markets.  Now that the economy is strong and inflation is uncomfortably high, the Fed no longer has the latitude to keep interest rates low to support the market.  Instead, there is a need to raise interest rates to mitigate against inflation.  As interest rates rise, consumer and corporate spending growth rates decrease, the economy slows, and long-maturity bonds and stock market performance face increasing headwinds.

The Federal Reserve’s monetary stimulus kept interest rates low but it has the effect of distorting markets by shifting investors towards risky assets.  As stimulus is phased out, markets may move down, and the move downward may be volatile and deep.

Asset price inflation (both stocks and bonds) pushed market prices well above average fundamental valuation levels by year-end 2021.  Valuation levels have moderated somewhat in 2022 but are still relatively expensive for long-maturity bonds and U.S. large cap stocks.

Investors have taken out record volumes of margin debt to finance their stock purchases.  Buying stocks on margin is extremely lucrative as long as stocks continue to move up, but a market downdraft would cause heavy selling to meet margin calls.  Option volumes are also at record high levels according to the Options Clearing Corporation.  Purchasing Options in a rising market allows much larger gains than buying stocks, but losses are amplified in a sharp sell-off.  Market makers who sell options to investors typically hedge their position by purchasing the underlying stock.  When markets decline and option purchases decline, market makers sell their stock holdings.  Although margin debt and option purchases have provided upward momentum, these trading tactics also have the potential to cause severe negative volatility.      

Evergrande is a Chinese property developer that defaulted on recent bond payments in its $300 billion debt holdings.  Other Chinese property developers are also experiencing cash flow problems, and the market fears “contagion” that spreads throughout the Chinese economy and international markets.  Optimists believe that the Chinese government will intervene to prevent any collapse.

Speculative red flags include GameStop, Bitcoin, AMC, Tesla and the proliferation of SPACs.  This speculative demand is driven in part by increased retail demand and especially investors who are confusing gaming with investing.  Current speculative momentum has reversed quickly.

Climate change constitutes a significant longer-term global challenge.  Although governments and corporations are taking steps to mitigate the impact, recent increased energy costs have caused a consumer backlash.  It is much easier to talk about reductions far out in the future, than it is to implement current steps to make actual changes.

Longer-Term Fundamentals:

Federal Reserve “Tapering”, Increased Interest Rates and Negative Performance:

The Federal Reserve’s belated recognition of inflation risks and its policy shift has spooked markets and caused negative returns for most asset classes so far in 2022.  The shift to higher interest rates is described as the end of easy money, and the narrative is now characterized as how high and how fast. 

The policy shift was publicized by the Fed on December 15, 2021 with commentary that they are ending their bond purchases and introducing a policy to raise short-term interest rates to combat inflation.  The government bond purchases began at the height of the pandemic to help support the economy and markets when businesses were closed and unemployment skyrocketed.  The government bond buying helped reduce interest rates.  (Interest rates on existing bonds declined because Fed purchases drove up bond prices and correspondingly reduced interest rates.)

 U.S. Economic Statistics are Positive but Weakening as inflation concerns increase.  Economic statistics dropped precipitously due to the government-induced shutdown in 2020, but then rebounded well above consensus expectations in 2020 and 2021.  Most recently, economic reports are showing a softening growth rate. 

-Retail sales have been stronger than expected although May dropped on rising  gasoline and food prices.  Fiscal stimulus has ending but U.S. households accumulated over $2.5 trillion in excess savings during the pandemic, and this should drive strong consumer spending in 2022. 

-Unemployment (at a 50-year low of 3.5% in February 2020) spiked to 14.7% as the pandemic shut down the U.S. economy, but has since dropped to 3.6% for May 2022.  Job creation for May came in at a solid 390,000 new jobs.  The overall employment trend remains positive as companies scramble to find workers to meet strong demand.  

-Industrial production gained 0.2% in May as supply chain constraints appear to be improving.  Industrial production is now up 5.8% on a year-over-year basis.  Semi-conductor chip shortages continue to be problematic, especially related to domestic car and light truck production.

-Housing has been strong due to low mortgage rates, but new construction is currently negatively impacted by rising mortgage rates and rising construction costs.  These rising costs impact housing affordability, especially at the lower price points for younger families.

-Inflation has been low over the past decade, but is currently increasing rapidly.  The Core Consumer Price Index came in at a trailing 12-month 6.0% annualized rate in May.  The Core CPI is now at the highest level since 1982.

-The Conference Board’s Leading Economic Indicators came in at -0.4% in May due to weak consumer expectations, a residential housing permit slowdown and inflation fears.  The Conference Board forecasts 2.2% GDP growth for 2022.  

-The European Union grew at a 0.3% quarter-over-quarter rate for the first quarter.   The EU has experienced slower economic growth due to the war in Ukraine and inflation, and lockdowns.  The EU is forecasting 2022 GDP at 2.7%.  The U.K. grew 0.8% in the first quarter.

-Japan’s 2021 Q4 GDP came in at a 5.4% annualized rate, up from a -2.7% decline in the third quarter when lockdowns had a larger impact.  Widespread COVID-19 lockdowns crimped consumer spending but Japan is expected to grow 3.3% for 2022 according to the IMF. 

-China reported 2022 Q1 .013% GDP growth, and 4.8% annualized, due to COVID containment issues and supply-chain problems.   China’s 2022 GDP growth goal remains at 5.5%, but the slowdown in the manufacturing and export sectors makes it increasingly unlikely that they will achieve their goal.

Performance:  U.S. stock indexes moved up to record-high levels based on government stimulus and optimism with COVID-19 vaccine in 2021, but performance so far in 2022 has been negative.   Energy, industrials, financials and small cap stocks have performed well in 2021as the market rotated away from some of the tech darlings.  Small cap stocks are cheaper and have more earnings upside as the economy recovers from the COVID-19 lockdowns. 

Longer maturity bonds underperformed in 2021 as interest rates rose, and are down even more in 2022.  While fiscal stimulus was necessary due to COVID restrictions and lockdowns, there is a growing concern related to persistent inflation and to huge government budget deficits.  Investors are less willing to accept historically low longer-term government debt, and this is pressuring long-maturity bond prices lower as yields move higher.

GameStop, Bitcoin and Dogecoin were big performers in 2021.  Retail investors have added volatility to speculative stocks in 2021.  They first targeted Gamestock.  They initially drove the stock up as they purchased the stock and call options on the stock, forcing hedge funds with short positions to cover their short positions.  Investors with short stock positions essentially borrow stock and then buy it later to close out their positions.  Investors take short positions when they expect the stock to decline.  GameStop has been a favorite stock to short because it is a bricks-and-mortar video game store with declining revenue and profits.  Short positions on stocks can be lucrative if stocks decline sharply, but are very risky when stocks rise.  Retail investors used Reddit’s WallStreetBets, web site to coordinate stock and call option purchases as they encouraged one another to upset the Wall Street status quo.  This was described as a David and Goliath story.  Although many retail investors achieved huge short-term gains and have forced huge losses on the hedge funds with short positions, there is little fundamental reason to hold these stocks on a long-term basis.  So far this year, these stocks have suffered big losses, and there is little fundamental support for these names in 2022.

Market valuations are down but are not cheap.  At this point, markets are trading on recession fears and the prospect of weaker corporate earnings growth.  Various valuation metrics (like Price/Earnings ratios) for 2022 are down but remain elevated compared to long-term historic averages.  It is important to remember that valuation doesn’t predict short-term performance, but valuation definitely impacts long-term performance potential.  In other words, markets could continue to get move up on a short-term basis, but the longer-term performance might be a 5-7% average long-term return/year rather than the historic 10%/year return.

Stimulus packages helped in the short run, but debt keeps growing.  Three stimulus bills have been enacted since the beginning of the pandemic in March 2020.  These bills are summarized below: 

-The $2.2 trillion CARES Act, passed quickly in March 2020, provided $1,200 direct payments and enhanced unemployment benefits.  

-The $900 billion Pandemic Relief Bill passed in December 2020.  This provided $600 in direct payments to eligible individuals and $300/week in extended unemployment benefits through March 2021.

-The $1.9 trillion American Rescue Plan passed in March 2021.  This plan included $1,400 direct payments to most Americans and extended additional unemployment benefits through the summer. 

The U.S. federal debt stands at $30 trillion, and is expected to continue to grow for the foreseeable future.  Although current interest rates remain low, future inflation could cause rates to rise, and this would cause sharply higher debt service costs.  This is clearly a headwind on a longer-term basis.

For more detail see:

Markets & Economics

Market Performance


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