“It’s the Economy Stupid!” (credited to Bill Clinton’s campaign manager James Carville in the 1992 presidential race)
After several crazy years with the focus on Covid, culture wars, and tribal animosity, we seem to have finally fallen back to classic economic issues with a huge geopolitical overlay. In fact, the economic headlines and storylines seem to be quite foreboding:
- Highest inflation in 40-plus years, bringing up scary memories of the stagflation of the 1970s
- Interest rates soaring with mortgage rates roughly 2% higher than just a few months ago
- Recession concerns rampant as the esoterically known “yield curve” has inverted at various points (e.g. the current 2-year treasury yields 3.25%, while the 10-year treasury only yields 3%)
- Federal Reserve, on the case with regards to attacking inflation, has made the biggest rate hike in nearly 30 years while also executing quantitative tightening (taking their cash from maturing treasury and mortgage-backed bonds without reinvesting, i.e. draining billions from the economy)
- Bear markets in stocks have “officially” (declines of 20%) hit in the S&P 500, the Russell 2000, and the NASDAQ 100 while the bond market has gotten off to one of its worst starts in history
- Russia’s brazen attack on the sovereign nation of Ukraine has caused food and energy prices to soar
How About Some Good News?
Most of these economic maladies seem to revolve around the somewhat recent phenomenon of sharply higher prices for food, gas, housing, used cars, etc. So, quite possibly, this seemingly very dark economic/market experience will turn around if and when inflation begins to cool. I want to mention some reasons to become (or hopefully remain) an optimistic investor:
- Market valuations have plummeted, undoing much of the sky-high levels, in particular, of the huge, mega-cap technology-related companies such as Amazon, Tesla, Microsoft, and Google’s parent Alphabet. Prices are much more reasonable.
- Supply chains are improving and inventories are being rebuilt – in some cases to levels of gluts – taking pressure off prices.
- Commodities have sharply reversed the previous meteoric rises with precipitous declines, once again proving the adage “the best cure for high prices is high prices”.
- Gasoline – perhaps the most prevalent commodity – has recently declined for 34 straight days.
- Housing mania has been replaced by a correcting market as higher mortgage rates have begun to impact demand
- Various inflation indicators found in the bond market have been showing declining future inflation expectations (e.g. the above-mentioned inverted yield curve). This might take pressure off the Federal Reserve allowing them to relax their relentless tightening campaign.
While I know that there have been myriad of doom and gloom forecasts, most really fall into just a couple camps:
- Stagflation. There are those who believe that the inflation genie is out of the bottle and the Fed will prove impotent in its ability to get inflation back to the 2% target levels of recent history. While inflation may come down somewhat, it won’t be enough. Furthermore, the Fed rate hikes will hinder economic growth enough that the economy stagnates. The adherents of this view fear a return to the dreaded 1970s scenario of high inflation and slow growth.
- Severe Recession. This camp believes that inflation is already turning lower and the Fed will basically overdo the interest rate hikes. In fact, like the stagflation camp, this group also believes that the Fed is impotent since inflation has been caused by supply issues (e.g. supply chains with Covid and the Ukraine war) while the Fed can only impact demand. They fear that as the supply issues gradually improve prices will fall but so will economic activity, perhaps severely.
Maybe there is another possibility …
My Most Rosy Scenario
I have to admit that this may not be a high likelihood possibility, yet it is definitely a possible scenario. It is basically built on a few premises:
- Supply chain improvements put downward pressure on inflation. It is possible that as supply continues to increase – not just in goods but perhaps in workers rejoining the workforce – that prices begin to settle back.
- The Fed makes perhaps one more hike then pauses to view the impact of its raises to-date. The Fed takes a break as they see some of the good inflation news noted above and want to avoid curtailing the economy too much.
- The economy experiences either a soft landing or a shallow recession. This might further take the edge off inflation while allowing the economy to rebalance and move back to its slow-growth, low-inflation trajectory.
Another benefit of my rosy scenario view would be that the interest rates would normalize meaningfully above zero where we might be able to finally earn a few percent in relatively safe investments including money market funds.
Stay Diversified and Nimble (repeat from April column)
<I have to admit most pundits and strategists much smarter than me do not expect the rosy scenario. And, I believe that nobody really knows since we’ve yet to be able to consistently, accurately predict the future. So, I think the best advice is the same as usual and thus I repeat below from my April column.>
So far, 2022 has been extraordinarily volatile with both stocks and bonds struggling mightily. In fact, it’s been the worst start of the year for many segments of the bond market in history. We may be on the verge of significant, disruptive changes in many of the financial trends that have been in place for decades. As always, the key is to patiently stay diversified in a broad variety of asset classes. Most importantly, if you are in retirement or planning for a future retirement (most of us are one or the other), be sure to maintain your long-term investing perspective with necessary allocations to a wide variety of stocks and be prepared to ride out any inevitable volatility.