Q2 Market Update - Inflation and Ongoing Market Volatility
The recent increase in inflation and the subsequent hikes in interest rates by the Federal Reserve (AKA the Fed) have wreaked havoc on markets, and this is proving to be no fun for investors. Stocks and bonds have both been hit hard, and the tech sector and “crypto” have been walloped. Although we expect continued turbulence ahead, there are signs of better news on the horizon.
FIRST, THE BAD NEWS
Inflation proves persistent
The previous headline inflation numbers (released in mid-June) were higher than expected and the markets reacted by selling off further. Both bonds and stocks took another leg down as markets expected the Fed to get more aggressive with their rate hikes. As is often the case the markets were correct and the Fed increased interest rates by 75 basis points (or .75%), up from the previously expected 50 basis points (.5%) hike. Unfortunately, if we get more inflation surprises to the upside then the Fed will remain aggressive, which means more pain ahead for investors.
The Fed Giveth the Fed Taketh Away
Inflation was caused by both “money printer go brrrrrrrrr” (a 33% increase in the US Money supply through “quantitative easing” and stimulus checks in 18 months) along with severely disrupted supply chains and the war in Ukraine. Unfortunately, the Fed can’t change Vladimir Putin’s mind or force China open its ports. They only have one tool to fight inflation, and that tool is ratcheting up interest rates to get everyone to spend less money. The Fed pumped too much money into the economy and now they’re attempting to pull it out by making it costlier to borrow.
Demand destruction could lead to recession
You may have heard the Fed refer to an attempted “soft landing” for the economy as they work to defeat inflation. As inflation remains high, and the Fed continues to hike aggressively, the chances of a not so soft crash-landing continue to increase. The increased odds of a crash landing are now priced into markets, but if inflation continues to surprise to the upside, then markets will continue downward.
AND FINALLY THE GOOD NEWS
Value Stocks Remain Relatively Strong
At Citrine we overweight value stocks (in comparison to growth stocks) in our portfolios, and value stocks have remained relatively strong in comparison to growth stocks. This has caused our portfolios to hold up relatively well.
Stock Prices are Becoming More Attractive
Stocks and bonds are now much more attractively priced than in 2021. This is beginning to look like a good opportunity to buy in with any extra cash. We expect a good buying opportunity over the next 3 – 12 months, which should allow ample time to dollar cost average (buy over time) at these lower prices. Keep in mind that the stock market could definitely go lower from here, but we are still entering buying territory.
Demand Destruction is Underway
We’re seeing signs that interest rate hikes are beginning to work. For example, commodity prices (including oil) have come down quite a bit, the housing market is showing signs of slowing, and some companies are beginning to lay off workers. I certainly don’t want to celebrate layoffs etc., but this is an unfortunate consequence of the Fed's actions. The quicker demand is destroyed the quicker inflation falls and the sooner we move to a pause or reversal in Fed policy. As soon as markets sniff a reversal in Fed policy, they will resume their trajectory upwards.
Any Upcoming Recession Should be Short Lived
If the Fed doesn’t overshoot too far when raising interest rates then any recession should be relatively short and mild. As soon as the Fed pivots and either stops tightening or begins to loosen monetary conditions the stock market will quickly pivot, and the underlying economy should follow. I would expect a recession like the 2001 recession if we do see one.
CONCLUSION
Inflation has been sticky and persistent, but we are seeing signs that it will begin falling soon. It’s possible that markets fall in the next few months however this is extremely tough to predict. It’s also important to keep in mind that the markets are forward looking - any positive inflation news or positive news on the Federal Reserve’s intentions will cause the markets to turn upwards even though the underlying economy will take quite a bit longer to recover. Of course nobody knows for sure when this pivot will take place, which is why it’s important to stay disciplined and invested, and remain focused on the long-term. With a steadfast long-term focus short term volatility becomes nothing but noise.