July 1, 2022
Main Street and Wall Street are concerned about inflation. This is understandable given consumer prices have been rising at over a 5% annual rate for more than a year.1 Clearly, this bout of rising prices is not transitory. Inflation is a particularly pernicious monetary phenomenon. It is a form of financial pocket-picking through the erosion of a currency’s purchasing power. People experience it at the gas pump, the grocer, and the department store. Now it is nearly everywhere, affecting everything.
When a populace becomes inflation aware, politicians become nervous for good cause. People do not like the decline in living standards that accompanies systemically rising prices. To place a finer point on the problem, the median American household income last year stood at $79,900. If inflation continues to rise at 8% throughout this year, the median household will see a $6,392 reduction in its spending power. As a result, the new income of that household will now reset to $73,508 in inflation-adjusted terms. Mr. and Mrs. Jones suffered a pay cut.
If the Joneses are lucky to get a pay raise but the increase is less than the rate of inflation, then they are in the terrible position of earning more but making less. This is exactly the state of play for most American households as real average weekly earnings growth has been negative since April of 2021. Rumblings of consumer concern are evident in measures of confidence (Exhibits B and C).
As inflation rises, confidence slides, which is a tough combination for investors and policymakers. High inflation is a wellspring for a disgruntled society, which drives political change.2 The failure in the late 1970s to arrest inflation, which was running at levels similar to current readings, was a key factor in Jimmy Carter’s losing the 1980 election – a fate no incumbent wants to repeat.
To the Rescue?
All eyes are on the congressionally mandated guardian of stable prices and full employment, the Federal Reserve, to see how it grapples with inflation. From our perch, the signs are not encouraging. The Central Bank is late at addressing the problem, lifting interest rates only twice this year. Furthermore, it only recently started to shrink the leviathan balance sheet created by its money printing of the last 3.5 years. With the 75-basis-point hike in rates in June, does one get a sense of urgency on the part of central bankers? Compare the shuffling and ponderous approach of the Bank to the galloping inflation of the last year, and picture forms of bankers fiddling while money burns.
Money and credit are the lifeblood of commerce. When scarce, growth is stunted. When abundant, growth follows but is often accompanied by misguided investment and, in some unfortunate instances, inflation. Sadly, the latter occurred over the last several years. The magnitude of distortions now in play is particularly problematic for central bankers and investors.
The challenge facing the Fed is immense. Scaling the size of the stock market to the size of the economy in which it operates reveals an enormous break between the size of the equity market and the size of the economy. The S&P 500 Index market capitalization stood at nearly 160% of GDP at the end of Q1, and is now at roughly 130%. The average since September of 1989 is 84.5% (Exhibit D).
Similarly scaling corporate profits to GDP reveals the potential for another reset. At nearly 12% of GDP, corporate profits are almost 20% higher than the long-term average of 10%. The corporate sector, despite enormous strides in capital and operating efficiency, has never durably operated above 11% of GDP. Our growing concerns about the health of operating margins in the corporate marketplace stem from this historical reality (Exhibit E).
Whether or not Chairman Powell et.al raise interest rates to 3.45% as the futures markets expect, will be a topic of much debate over the remainder of the year. Expectations and circumstances change, but the problem remains: the challenge of monetary normalization is going to be a heavier lift than many think, given the economic and financial distortions of the last decade.3 The recent actions taken by the Central Bank are likely the beginning of a war of wills and attrition between a generation of investors who have no experience navigating inflation and a central bank that appears to be using woefully ineffective models to forecast the impact of its policies.
The churn in asset prices continues, with market volatility across asset classes remaining elevated. Global stocks are in a bear market and global bonds are down roughly 14%.4 Long treasuries are also in bear market territory, accompanying U.S. stocks.5 Frustrating Wall Street and Main Street is the reality that portfolio diversification has not worked this year. How could it? When interest rates rise as inflation rages, equities and fixed income investments both struggle. The ballast provided by fixed income offers little protection when that ballast fails to float. Cash has been a “safe-ish” haven as it holds nominal, but leaks real value. Gold has been the big surprise this year as it has barely registered a positive return. Digital gold in the form of Bitcoin, etc., has failed the stress test as a store of value in a world beset by inflation and geopolitical turmoil — both have lost enormous value this year. One estimate reckons the value of crypto assets has fallen from $2.9 trillion to $835 million.6 The utter failure of crypto assets to perform this year should put paid to the notion of bitcoin and its ilk as a currency.
Another curious development is the resiliency of international markets. Headlines blaring inflation, recession, war (in some cases prefaced by “nuclear”), and energy shortages would suggest international markets falling more dramatically than the U.S. Yet on a local currency basis, broad European markets have turned in similar or better results than U.S. markets. On a dollar basis, international markets are roughly in line with the U.S., which suggests investors are not penalizing international markets more harshly for the unsettling news flow (Exhibit F).
During our client broadcast in May, we asserted that elevated market volatility would be an enduring feature this year. Rising interest rates and a shrinking money stock will likely intensify price swings as market liquidity resets. This recalibration will likely accompany lower price-earnings multiples for U.S. equities. This re-rating of multiples is not a linear affair. Rather it unfolds with market volatility and negative-to-muted market returns against the backdrop of earnings growth. This type of market environment may feel like a bear market but might not necessarily be one in the classical sense. Cruelly, bear markets feature vertiginously powerful rallies that ultimately dash hopes when the gains vanish by subsequent market declines (Exhibit G).
Trading this volatility is devilishly difficult and avoided unless one has an army of quants armed with supercomputers that are co-located with exchange servers. A better strategy is to look through the volatility and pay attention to portfolio construction, making sure one’s portfolio remains fit for purpose. Focus on cash buffers, position-sizing, and asset class exposure. Make sure these aspects of one’s portfolio align with one’s risk tolerance and return requirements. Moreover, volatile times such as these offer the opportunity for harvesting losses to offset future or recent gains. Harvesting a loss is a great way to make useful something that is painful.
The second half of this year has the potential to test resolve. Policy uncertainty that mid-term elections bring; central banks that appear not to have the confidence of markets; and the vicissitudes of war, pandemic, and inflation combine to create a climate perfect for continued turmoil across markets and roil within them. While the economy battles inflation, de-globalization unfolds, war is waged, and political winds swirl, it seems clear the Great Moderation of the last 40 years appears to be ending (Exhibit H). (See “Q2 Market Outlook: The End of a Golden Age”)
Market regimes change and with them, the way to profit changes as well. If the new regime is one that features higher inflation, interest rates, and more active government regulation on the market power of large tech firms, then the leaders of the last decade will likely struggle to maintain their position.
Companies that have consistent profits, strong balance sheets, and dividends — in short, higher quality companies — will likely find renewed favor with investors. Lower quality companies may look more compelling from the perspective of debt holders as yields rise. Elsewhere on the fixed income front, once the yield curve normalizes such that inflation-adjusted interest rates are no longer negative, then Treasuries may re-emerge as a viable contributor to investor portfolios rather than simply serving as tactical dry powder. Until then, a defensive posture is in order.
1 Monthly reading of the Consumer Price Index on a year-over-year basis
2 The rail strikes currently plaguing England are a result of frustrations that inflation-driven declines in living standards have created
3 Probabilities based on Federal Funds Futures via Bloomberg
4 Global stocks are measured by MSCI All Country World Index and global bonds are measured by Bloomberg Global Aggregate Bond Index
5 Long Treasuries returns measured by the Bloomberg U.S. Treasury Long Index, which tracks treasuries with maturities greater than 10 years. U.S. stocks are measured by the Wilshire 5000 Index
6 Unhedged, Robert Armstrong, Financial Times, June 20, 2022, citing CoinMArketCap data