Capital markets, where to even begin? It has been a challenging ~12-months for stocks. Going back to summer 2021, we saw stocks trade in a tight range, taking one step forward, only to then take two steps back. Then, from November on global stocks fell more aggressively, hitting lows of more than 19% down. Several major stock market indices such as the Russell 2000, and the NASDAQ have crossed the -20% threshold into official bear market territory.
It remains to be seen if markets have hit bottom, or how much bleeding is still to come.
Currently, there is a crowded field of market drivers, investor sentiment which is always the paramount driver over the short-term, the fallout and potential escalation of the Ukraine vs. Russia War, INFLATION, Fed policy, lockdowns in China, and now economic recession.
Let’s start by looking at YTD performance (as of 5/18/22) of major capital market indices and a chart for global stocks.
- Global Stocks: -17.06%
- US Stocks: -17.24%
- International Developed Stocks: -15.26%
- US Aggregate Bonds: -9.52%
Investor Sentiment
When there are more buyers than sellers, stocks rise, and the converse is true. Investor outlook is influenced by all the other above-mentioned drivers, but ultimately it is the buying vs. selling sentiment that moves prices in the short-term. In an environment where all major drivers appear negative there are numerous opportunities for the story to shift positive and change the market direction.
Ukraine vs. Russia War
Initially when Russia invaded Ukraine, there was fear of escalation and the potential for a nuclear WWIII. While that risk remains, the probability is very low, and a more known quantity. The economic fallout from the conflict is complicated to calculate and predict. It is not as easy as subtracting the economic output of Ukraine and Russia from the world equation like one could remove a puzzle piece. The interconnectivity of global economies are vast, and the ripple effects of each action are essentially endless. That said, once the war broke out economies immediately started to adjust and adapt based on the new environment. Free economies are nimble, highly resilient and may adjust to this new environment better than initially expected.
A longer-term effect of the war might be a reduction in the use of US dollars as preferred reserve currency. If the US Gov. is willing to use the dollar as a means by which to manipulate and force the hand over foreign governments as it has with Russia, then other foreign governments (& entities) may explore alternative options. In theory, if the US dollar were to decrease in reserve currency status, it would weaken the dollar vs. foreign currencies. This could result in a positive effect for American workers and domestic production, while simultaneously increasing consumer costs (higher inflation), and decreasing available credit to individuals, businesses and government. For investors it would increase the attractiveness of international stocks.
Is war good for the economy?
No. There are beneficiaries in war, but as an aggregate war is an economic negative. It forcibly reallocates capital and resources. Additionally, war comes with destruction of property and human destruction. This means that capital and time that otherwise would have gone to some other new positive production, instead goes to rebuilding, and the dead are lost forever. Economists refer to this myth as the broken window falsely. Think about your home. If all the windows in your home were suddenly broken from vandalism or natural disaster and they needed to be replaced this would not be a positive economic development. Sure, the window company might benefit from the job, and the new windows might even be better than the old ones, but the money, time, and labor used to replace all the windows would have been better served elsewhere. Even if something is rebuilt/remade better than it was before the destruction, the cost of that destruction is always negative in real terms.
Inflation
Inflation numbers continue to come out, and the story mostly remains the same. Inflation is very high, and therefore, purchasing power continues to erode at a rapid pace. There is some recent evidence that the pace of inflation may be slowing. However, slowing inflation when the starting point is all-time highs is not much consolation for Americans in the grocery store or at the gas pump. For a more detailed take on inflation see my previous two newsletters: Will Prices Keep Going Up in 2022? & Inflation 2.0. In the short-term inflation is a negative force for stocks, bonds, consumers, companies, etc., etc. There are some beneficiaries of inflation though, namely commodity prices, and debtors. The biggest beneficiary of inflation is the Federal Gov., because it is the world’s greatest debtor. Over the longer-term stocks remain the best returning asset class after adjusting for inflation, even if prices are reset lower in the short. Value stocks, tend to outperform growth in inflationary environments.
Fed Policy
After spending 2021 denying the existence of inflation, then insisting it would be temporary, now the Fed insists it will fight and end inflation. They intend to raise the Fed Funds Rate by 0.25-0.5% incrementally, while also ending QE Treasury purchases. I read their intentions as hoping with time inflation will cool itself. Chairman Powell recently said that he admired Paul Volcker (Fed chairman 79-87) not because he aggressively raised rates and fought inflation, but “because he did what he thought was right.” It seems likely that chairman Powell might believe a different course of action is “right.”
A case for Bottom
If you believe as I do, that we are amid a recession, and the late-July report will only confirm it; then history would tell us that we are near a market bottom (if we haven’t hit it already). The stock market cycle tends to lead the economic cycle, whence why it is referred to as a ‘leading indicator.’ This is not to say that markets can’t fall an additional 10+% from current levels. The point is that if markets have not hit bottom yet, they likely will over the next ~40 days.
Theme Changes
When looking at history we find that market cycles tend to have sweeping macro characteristics that play out for long stretches, I refer to these as themes. There have been long periods of outperformance by Japanese stocks, US large growth, US tech, International DM, emerging markets, etc. vs. the relative market. Typically, those periods of outperformance are followed by relative underperformance and the emergence of a new leading category. I believe a transition to new leadership is taking place. Post 2008 US large/mega-cap growth stocks have had tremendous outperformance relative to the broader market. This has led to multiple expansion in those stocks, and big spread between other category multiples vs. US large growth. Below you will see the forward price-to-earnings ratios for these major categories of stocks, coming into this week.
- US Growth 23.5x earnings
- US Value 14x earnings
- International Developed 12.5x earnings
- International Emerging 11x earnings
The mean for US growth over the last 20-years is 18.5x earnings. This tells me growth may have further to fall, despite being -23% YTD already. By contrast US value stocks YTD performance is -6%.
When markets fall and the world appears to be in chaos our human nature works against our investor best interests. Our nature is emotional, and our emotions trigger our fight or flight instincts. In these times it is more important than ever to remain calm and revisit our investment policy. Lean on a clearly defined set of principles and process for making decisions.
Be well,
Wyatt Swartz
Financial Adviser, RIA
W. Swartz & Co.
(636) 667-5209 | www.wswartz.com
There’s REAL & reported inflation.
2021 = Highest Inflation
I would like to quickly follow up from my previous message regarding inflation.
The numbers for December inflation were released, and now we have numbers for all of 2021. Inflation judged by the CPI Index rose 7% in 2021, the largest 12-month increase since the period ending June 1982.
As previously mentioned, the method for calculating CPI today is different than it was in 1982. Using the previous method of calculation, 2021 would have been the highest CPI in history.
Today inflation in housing costs is largely measured in the CPI using something called “owners’ equivalent rent.” I will spare you the wonky details of what it is, but say it drastically underreports housing cost increases. Owners’ equivalent rent was reported as increasing 3.8% in 2021. In 1982 the BLS was using “home prices” for that component of the CPI. Home prices rose in 2021 by more than 16%.
If you replace “owners’ equivalent rent” with “home prices” you get an inflation rate of 10% for the 2021.
I believe high inflation will force a rotation of leadership within capital markets.
As I write this…
US large cap stocks are -0.58% on the day.
US large cap VALUE stocks are +0.23% on the day.
International DM large cap stocks are -0.29% on the day.
International DM large cap VALUE is +0.60% on the day.
The shift in capital markets will not be as clean each trading day as it appears today, however I do expect it to continue to play out for the “foreseeable” future.
Sincerely,
Wyatt Swartz
Financial Adviser, RIA
W. Swartz & Co.
(636) 667-5209 | www.wswartz.com
Inflation was the biggest economic topic of 2021, and I believe this will continue through 2022.
Inflation might not be as temporary as the Federal Reserve would have liked us to believe. They’ve prefered the term“transitory” to “temporary”, I suppose to sound more sophisticated.
Prices are up everywhere, and folks are understandably upset at paying more at the grocery store, gas station, and most everything else.
Many analysts hoped that data blips, supply chain clogs, and other pandemic-related disruptions were creating a temporary spike in inflation that would quickly resolve.1 This hope was shareed by the Fed which pushed the “transitory” narrative most of 2021.
They were wrong, and 2021 saw a constant stream of reports detailing surging inflation numbers. The Fed has more recently capitulated and admitted that inflation might be more sticky than advertised.
Prices have increased 6.8% over the last 12 months (through November) — the biggest spike in 31 years. And you can see in the chart that some categories measured by the Consumer Price Index (CPI) have soared by much more.2
The reality of inflation is much worse than the official numbers show. There have been adjustments to how CPI inflation is calculated, and an apples-to-apples comparison inflation is at levels not seen since the early 1980s.2 I have seen multiple estimates that put inflation above 12% when using the older methodology.
What is inflation?
Inflation is a decline in purchasing power of a given currency. Said another way, it is when prices go up, and it costs more money to buy the same good or service. The term has changed over the last century. In the 1800s inflation meant an increase in the money supply, and it was simply understood that increasing money supply leads to higher prices. It is possible for prices of some goods/services to increase without an increase in money supply if those goods or servies become more valuable or scarce.
What is deflation? Is deflation negative for economies?
Deflation is the opposite of inflation. It is when prices generally fall, and purchasing power increases. If the money supply were to remain constant, then a constant deflationary environment (vs. inflationary) would occur within free-enterprise economies. This occurs because production increases over time, and the increase in production leads to decreased prices.
Deflation is not negative. This is a very commonly held myth. One of the most extensive deflationary periods in US history, was 1869-1879. This period saw prices generally fall by 3.8% per year. Yet, it coincided with 3% per year increase in national product growth, 6.8% per year growth in real national product, and a phenomenal 4.5% per year in real product per capita. It was one of the most expansive economic periods in US history, all occuring during deflation.7
Devaluation vs. Inflation: What’s the difference?
When the quantity/supply of money (in our case Dollars) increases, the value decreases. Money devaluation is often accompanied by inflation, but this is not an absolute, and that is why today we differientiate between devaluation and inflation.
Prices for some goods and services can remain the same, and even decrease while money is being devalued. This occurs when productivity outpaces the increase in money supply. In this scenario, if money was not devalued, prices would have fall.
Gresham’s Law: Legally overvalued money tends to drive legally undervalued currency out of circulation.
Can the Dollar Strenghten with inflation?
Yes, if foreign currencies are devalued/inflated at a higher magnitude relative to US Dollars, then the Dollar will strengthen relative to those other curriences. For most of the 1900s, European countries inflated their currencies, in some cases to the point of collapse. The US Government & Fed spent most of the 1900s engaging in inflationary practices too, but the magnitude was not nearly as severe as European counterparts. This eventually led to the Dollar taking the position of world reserve status.
Additionally, if one currency is simply perceived to be more valuable it will strengthen relative to other currencies without changes to the existing quantity of either currency. The classic example would be that of a currency in a country where the government in power is seen as unstable.
2021 saw massive inflation in the US, and a strengthening dollar.
How does the Federal Reserve System “the Fed” fit into this?
In theory, the Fed is an independent (of the Gov) central bank whose primary function is to ensure a sound money. The Fed is supposed to act as a check on the Government, on behalf of American citizens.
The Fed is supposed to increase money supply during periods of economic expansion, preventing deflation, and stabilizing prices. Conversely, the Fed is supposed to decrease money supply during econonmic contraction, preventing inflation, and stablilizing prices.
Since its creation, the Fed has rarely acted as a check on Government. It has redifined and expanded its mandate multiple times, and has mostly acted as the chief enabler of the Government budget deficits.
Despite economic contraction during the pandemic, the Fed increased money supply. Thereby creating a massive perfect storm of less production (supply curve) and more money (demand curve). Freshman microeconomic students can tell you that when supply curve decreases and demand curve increases, prices rise.
The circumstances of the last two years were unique and may have called for unique policies by the Gov. and the Fed. That is a political question, that is irrelevant to our discussion.
The policies of the current and previous administrations, and the Fed policies were inherently inflationary.
Is inflation “transitory?,” temporary if you prefer?
The answer is entirely dependent on perspective. Inflation, has been nearly constant at varying magnitudes ever since the Federal Reserve System was established in the early 1900s. It will likely continue to be a constant barring major reforms to the US monetary system.
There is no reason to be optimistic about inflation looking out for the next 100-years under the current system. The Government is unlikely to ever meaningfully cut spending, or meaningful raise taxes. Therefore, the path of least resistence is to print more money, devaluing the dollar, and creating long-term inflation.
Over the shorter-term, there are reasons to believe the elevated magnitude of inflation will fade.
First, natural supply and demand forces favor a redution of inflation. In free markets, when prices rise rapidly it increases the incentive to increase production/supply, which… reduces prices. You could say that “high prices today eventually lead to lower (or at least stable) prices tomorrow. Said another way, it is hard to sustain this pace. Eventually, it runs out of steam.
Second, there were unique inflationary actions occuring in 2020 and 2021 that are unlikely to continue. Economic activity in the US and all over the world was forcibly stopped (halting or decreasing production – supply curve), while money was increased (increasing demand curve) and directly injected into cirulation. Neither of these actions are likely to occur at the same magnitude in 2022 as occurred in 2021 and 2022.
It is important to point out that even if we do see slower rises to inflation numbers in 2022, doesn’t mean falling prices. Erosion of purchasing power is still happening, just at a slower pace.
Specifically, 2022 what is the inflation expectation?
Through November, consumer inflation rose 6.8%. However, producer prices rose 9.6% over the same period. That gap will be passed on to consumers in 2022. The gap between producer and consumer prices indicates high inflation numbers still to come.
The Fed has reduced purchases of Treasuries (tapering), and indicated they would possibly begin raising interest rates soon. In the late 1970s into the 80s, then Fed Chair Paul Volcker aggressively raised interest rates to fight inflation. Many believe the Fed will take similar action today, but I do not see any indication this will happen. Raising interest rates would put significant fiscal/budget constraints on the Government. The Government would struggle to service the debt were interest rates to significantly rise.6
2020 was the first time in 20 years foreigners were net sellers of US Treasuries. This is another indicater of a weakening dollar and inflation.
My expecation for 2022 is continued high inflation with low interest rates.
What are the investment implications of inflation?
Inflation will likely lead to a category rotation within stocks. For the better part of a decade, growth stocks have led their value counterparts. If inflation, continues to persist I expect value to outperform relative growth. In an environment where future earnings are valued less, earnings today are valued more. Companies that make money today are more attractive than companies that will grow and eventually make money tomorrow.
If we see a weakening dollar, this will make international stocks more attractive relative US. International stocks are already at a major discount relative US. A shift to value, inflation, and a weakening dollar could create a great environment for investors in international stocks.
Fixed income investing will continue to be challenging, and investors will need to be creative. Investors with cash flow needs from their portfolios typically need to use fixed income assets to steady returns. Historically owning a diversified portfolio of US Treasuries was sufficient, but that hasn’t been the case for the last 10+ years and will not be in the foreseeable future. Investors will need to utilized securities that are correlated with residential housing, private credit markets, inflation hedged, and international bonds. All while keeping the more traditional bond holdings at low relative duration to avoid the risk of rising rates.
Rising rates? Yes, but I do not foresee a significant rise. If the Fed had any intention of meaningfully raising rates to dampen inflation they would have begun the process in 2021. It seems the Fed’s plan is to cross fingers and hope the problem resolves itself. If the Fed aggressively raised interest rates it would force the Gov. to make drastic budget cuts, raise taxes, or print more money (leading to more inflation). The Government is broke, but low interest rates allows the status quo to remain. This is why I believe we will continue to see high inflation with historically low rates.6
Inflation is negative for US citizens, and negative for economies. At high enough magnitudes inflation can lead to recessions, depressions, and even societal collapse. None of which are high probability events, currently.
In an inflationary environment stocks generally remain the superior asset classs.
Wishing you and yours a HAPPY NEW YEAR!!!
Sincerely,
Wyatt Swartz
Financial Adviser, RIA
W. Swartz & Co.
(636) 667-5209 | www.wswartz.com
P.S. It’s the time of year when the analysts start making predictions for 2022. What are your predictions for next year? What will be the big themes? Hit “reply” and let me know your thoughts!
1https://www.cnn.com/2021/11/13/economy/what-is-inflation-explainer/index.html
4https://www.bls.gov/news.release/cpi.nr0.htm?mod=djem_b_reviewpreview_20211110