Since the beginning of the year, the markets have been rattled by persistently high inflation and the question of how the Federal Reserve might respond. Volatility is back, with a vengeance. On Thursday, May 5th, the Dow dropped over 1000 points after being up over 900 points the day before. The broad stock market is in the middle of a double-digit decline and there have been sharp moves lower in many sectors of the bond market.
We want to review some factors contributing to the current market decline:
Generationally High Inflation
Between March 2021 and March 2022, inflation in the United States rose 8.5%. This represents the sharpest inflationary increase since 1981. Many believe the main catalyst of this inflationary surge has been the pandemic. It has become more expensive both to produce and ship a variety of goods – everything from computer chips to furniture. Just as it looked as if the supply chain issues were improving, China again locked down their economy in an effort to implement its zero COVID policy. This continued stress in the global supply chain keeps raising investor concern.
As we moved through COVID in the US, the lockdowns and social distancing measures used earlier in the pandemic began to loosen. Consumers, flush with cash due to increased wages and lower borrowing costs, began to spend more on limited goods and services. The simultaneous occurrence of increasing demand and a lack of supply has caused significant price increases.
COVID has also affected inflation in other ways. Wages have gone up in multiple industries due to a shortage of workers. To compensate for the increased expense of paying workers, many companies have raised prices on the goods and services they provide.
The pandemic has also indirectly increased home and rental costs. When COVID emerged, the Federal Reserve made it practically free to borrow money by lowering interest rates to near zero. This was to encourage people and businesses to spend money rather than save it, thereby buoying the economy. This worked, but it brought several side effects. For example, low interest rates made it easier to buy a home, leading to a sharp increase in demand. This increase led to higher property values. According to Zillow research, the U.S. housing market grew by $6.9 trillion just in 2021. Home prices have now increased to a point that for many people, buying a house is not feasible. More recently, the Fed had to raise rates to contain inflation. This has impacted mortgage rates, which are now rising steeply, impacting affordability. Many potential homebuyers are continuing to rent. This has led to a sharp increase in rental costs and in some parts of the country, rents are all all-time highs.
Lastly, Russia’s invasion of Ukraine, and the subsequent sanctions, have caused commodity prices like oil, gas, precious metals, wheat, and corn to increase.
The Fed Response
In March, the Fed commenced increasing rates with a 25 bp (bp = basis points, 1 bp = 0.01%) rate hike in the fed funds rate to 0.25%-0.50%. On May 4, the Federal Reserve announced it would lift interest rates via the federal funds rate by a half-percentage point. This represents the largest single rate increase since 2000.
The Fed is increasing interest rates in an attempt to bring down inflation. As mentioned above, low interest rates led consumers and businesses to borrow and spend. By increasing interest rates, the Fed is hoping they will reward saving over spending, and hopefully lower inflation.
Historically, raising interest rates has been an effective way to dampen inflation. For example, from 1965 through 1982, inflation increased rapidly, peaking at 13.5% in 1980. To combat inflation, then-Fed chairman Paul Volcker initiated a policy of dramatically higher interest rates, with the federal funds rate increasing to over 19%. This policy change worked, with inflation normalizing by 1983.
A potential consequence of increasing interest rates is creating a recession, and there are historical examples of the Fed tightening leading to an economic contraction. However, the Fed is hoping for a “soft landing”. A soft landing is when consumer spending and economic activity slows down enough to lower inflation, but not so severely that the economy stops growing and businesses start laying off workers.
Investors are concerned that the Fed is too late in raising rates and the current strategy leaves little margin for error. Even though Paul Volcker’s strategy to lower inflation in the early 1980s worked, it led to a “double dip” recession from January-July 1980 and July 1981-November 1982. Conversely, the Fed accomplished a soft landing in 1994-95, when the Fed doubled interest rates to 6% and the US avoided a recession.
We believe the Fed is currently walking a tightrope, with high inflation on one side and unemployment on the other, and this is creating uncertainty in the financial markets. Time will tell whether the central bank can keep its balance. Much will depend upon how much the Fed raises interest rates and how long global supply chain issues persist.
Current expectations are for the Fed to raise rates another 200bps (8 hikes of 25 bps each, or combination of 50 and 25bps raises). Given the adverse impact on the economy, it is possible the Fed will not raise rates by this amount.
What Will It Take To Stabilize The Markets?
Markets tend to be forward-looking, reacting less on what is happening now and more on what it expects to happen in the future. 2022’s volatility is a perfect example of this. The markets are trying to price the end of the “free money” era. Also, the Fed has started to let the bonds it purchased in 2020 and 2021 runoff its balance sheet in a measured fashion. In other words, investors are not only dealing with higher interest rates, but the unwinding of quantitative easing which is creating additional uncertainty.
With four months behind us, the S&P 500 Index is off to its worst year-to-date start since 1939.
High inflation, concern about the Fed, slowing global growth, and the ongoing war in Ukraine are well known factors. The pullback in stocks reflects the high level of negative sentiment. To some degree, the headwinds are reflected in the market’s price. We avoid calling bottoms or tops. “Experts” in the financial news media may be smart, but they don’t have a crystal ball nor are they held accountable for their predictions.
The following are some possible events that may become catalysts for a market bottom:
- De-escalation in the Russia/Ukraine conflict
- Inflation having reached a peak
- Improvement in the supply chain
- Investors realizing that equity and bond prices represent a good value
- More confidence in the Fed’s strategy
The rest of 2022 is going to interesting. Headlines – economic, financial and political – will continue to raise eyebrows, stir debate, and even cause further stress. However, our long-term strategy accounts for all phases of market cycles and this cycle will likely prove to be no different. We will continue to keep you updated as we navigate through these turbulent times.
Have a good week,
Dennis P. Barba, Jr.
President & Managing Partner
Glen Kashetsky
Partner & Managing Director
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. Any market prices are only indications of market values and are subject to change. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. CAR-0522-01686
