My F&M

Market Update

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“The way prices are rising, the good old days are last week.”
-Les Dawson (comedian and author)

The first half of 2022 was the worst first half of a year for stocks in over 50 years. The Russell 3000 Index returned -21%, the S&P 500 -20% (and the Tech-heavy Nasdaq Composite Index was off 30%). Taxable bonds were down more than 10%. International stocks fared just a little better than US stocks, and the performance of smaller-company stocks was worse than that of large stocks. These declines are mostly a function of assets having been too expensive at the end of last year coupled with the return of serious inflation after a long absence. Without this resurgence of inflation, the Fed would likely have continued to remain accommodative (i.e., to have continued to provide excess liquidity to the banking system) and asset valuations might have remained elevated. Now, as valuations have significantly corrected but inflation persists, we’ll focus this Update on inflation. 

We’ll begin by looking back at several points we wrote about inflation in recent Market Updates for context. At the beginning of 2021, we were concerned about the possibility of rising inflation because the money supply had increased by 25% over the prior year coupled with lots of prior fiscal stimulus from the government. Then, the $1.9T stimulus bill passed, increasing concerns that abundant liquidity would lead to inflation, the one thing that would cause the Fed to restrict liquidity. Later in the year, when inflation began to turn up, we warned inflation may not be transitory and that the intrinsic values of stocks had not kept up with stock prices. (See quotes from several prior Updates below.)

So, we are now in exactly the spot about which we expressed repeated concern in various Updates: a rise in inflation that forced (in March) the Federal Reserve to change its posture from accommodative to restrictive. Moreover, this is not just a meaningful whiff of inflation, it is the largest outbreak of inflation in 40 years. The important question about inflation now for markets (and the Fed) is: when will it stop getting worse and start to ease? We don’t know, but we note some relevant items that have not gotten much notice yet: as of 7/1, the price of crude oil futures had fallen by 20% from its recent high, the average price of corn, wheat, and soybean futures had fallen just over a third from their recent highs, cotton prices are down 38%, and Copper, the most economically sensitive, is off nearly 28% from its recent high. Commodity prices are notoriously volatile, but this is an encouraging sign for moderating inflation, even if a negative signal for the economy. 

More significantly, the year-over-year growth in the money supply which had been runaway as we bemoaned a few times in the Updates cited above, has now declined to +8.0%, which is less than the most recent CPI inflation reading. Money supply growth (M2) less inflation is usually positive and last month was its first negative monthly reading in 12 years. As to swings, in the past 15 months, M2 growth less inflation went from its fastest pace of growth in 15 years to its slowest. The full impact of higher home prices has not yet worked its way through the CPI’s imputed rent component, and changes in money growth impact inflation with long and irregular lags. However, it is beginning to look like eventual lower inflation (after home price increases have worked into the numbers) may be getting baked in now just like higher inflation had looked like it would become a concern before it jumped. Note also that prices don’t have to fall for the rate of inflation to moderate, they just have to flatten out for a time. We’ll see.

Until then, stocks may face headwinds and continued volatility. That doesn’t mean stocks must decline until inflation turns down - though they likely will if the economy clearly slips into recession - but it will likely be hard for stocks to rise on a sustained basis until inflation begins to improve.

Inflation is quite enough to worry about, but markets must now additionally be concerned with the related prospect of recession. Inflation may get worse before it improves, but will turn down eventually, we just don’t know how soon. Yet how soon matters a great deal because the Fed is likely to continue to press rates higher until inflation eases. And the faster and higher the Fed pushes up interest rates, the greater the likelihood of a recession. The next two interest rate increases are likely to bring short-term rates above long-term rates into the condition known as an “inverted yield curve”, which generally implies short-term rates are high enough to cause a recession. The next Fed interest rate increase is expected this month and the one after in September. If inflation happens to moderate before then, the Fed may not push short rates that high.  We’ll see, but time to avoid a Federal Reserve-induced recession could be running out (if one hasn’t begun already).

The prospect of higher inflation for a time, with higher interest rates, means longer-term bonds still don’t offer attractive risk prospects and that our emphasis on inflation protection in various asset classes will likely continue to be rewarded. Separately an increasing likelihood of recession means our emphasis on quality in stocks will also likely be beneficial. As mentioned in our last Update, bear markets bring opportunities to defer capital gains taxes, and volatility increases both the opportunity for rebalancing and the benefit therefrom. 

Some may assume our general avoidance of market timing may mean we treat bear markets like any other episode, but that is not the case. In addition to the extra opportunities detailed above, the most common activity we engage in during bear markets is to reassure clients. For those still saving, pullbacks in prices clearly mean opportunities to buy at cheaper valuations.  For those already retired, we note the market value changes they see (and sometimes dwell on) are not the most useful things on which to focus. In retirement, spending is generally funded more by generated portfolio income than by sales of portfolio principal, and portfolio income historically has been quite stable with a bias to long-term growth.  In general, portfolio income has not declined this year for clients. The more we can focus attention on the income portfolios generate, the better investors we all will be.

Here are the excerpts from prior Updates referenced above:

1/4/2021 Market Update
Another near-term concern is the possibility of rising inflation. The money supply has risen nearly 25% over the past year … that’s a significant concern as we move later into 2021. It’s well known that the Federal Reserve has committed to an accommodative monetary policy for an extended period. We think that characterization is inaccurate. Instead, we think the Fed intends to remain in an accommodative mode essentially forever to the extent tame inflation allows, and that it will do so until inflation increases … the reason higher inflation is likely to have severe consequences for markets is that it would be the catalyst to change the Fed’s posture. 

2/1/2021 Market Update
Inflation:  We’ve written of this danger before … we note the most common measure of the money supply has expanded nearly 27% in the past twelve months … [we] are entirely confident a higher inflation scenario, should it occur, would greatly upset markets since it would force the Federal Reserve to reverse its easy money policy.

4/2/2021 Market Update
Many think the … $1.9T stimulus bill may be over-stimulus, eventually leading to inflation and a need for the Fed to tighten.  And close on the heels of the last give-away comes talk of much, much more and perhaps too soon, as some are beginning to fear this porridge may too soon become “too hot”.   If a rude discovery is made that free money isn’t free, that may not sit well with either the economy or markets. 

7/1/2021 Market Update
That inflation turned up significantly was no surprise.  The question is whether higher inflation will be transitory or persistent.  … We’ll have to see.  What we do know is this is the most urgent unanswered investment question of the hour … The reason is any moderation in accommodative Federal Reserve policy will be dictated by future inflation, Fed policy in turn defines liquidity, and liquidity drives markets ...

10/4/2021 Market Update
If higher inflation is not transient, the Fed will be unable to remain accommodative and markets would likely retrench.  We don’t know how this will play out, but we recognize danger to markets from inflation that may be stickier than markets currently expect, and this may not be sufficiently appreciated …

 … conditions remain positive for markets, but it’s a fragile positive, and inflation appears to be the thing with the best chance of upsetting it.  The world is awash in created money that has bid up stock and home prices.  That’s nice, of course, but underlying, intrinsic values have not risen as much and inflation may test that, particularly if it forces the Fed to a tight money mode. 

1/3/2022 Market Update
Economic growth is booming.  However, inflation remains a looming question, and the Federal Reserve, which had formerly labeled the price surge “transitory,” recently removed that word from its communication, implying more concern about inflation as a longer-lasting problem.  “Owner’s equivalent rent” represents nearly a fourth of the Consumer Price Index (CPI) and the … lags built into the convoluted calculation of this part of consumer inflation mean home price jumps which have already occurred are likely to boost inflation readings for several months to come.