Five Questions About – Inflation, Interest Rates and Investing
- The Federal Reserve just announced a 50 basis point hike – the second increase since mid-March. The move is designed to slow the rate of inflation which has continued to drive up the cost of goods and services in the U.S. The Fed has indicated that it could raise rates up to six times in 2022. Add to that the report late last month that the U.S. GDP actually shrank in the first quarter of ’22 and concern is building about the economy. Do you think the stated Fed plan regarding inflation will ease the recent investment market decline?
It’s important to understand what drove the decline in real GDP (GDP minus inflation) before we know if we need to worry or not. We get worried when the decline in economic activity is driven by a downturn in personal consumption, business investment or both.
In that regard, the report was OK. Compared to last quarter, personal consumption expenditures (PCE), the things you and I buy, were up 2.7 percent. The Services measure was particularly strong, up 4.3 percent, as post-pandemic spending has been shifting away from goods and toward services. Gross private domestic investment was also positive, up 2.3 percent.
So, what caused the contraction? The biggest contributing factor was related to trade, imports and exports. Exports increase GDP while imports are a drag. During the first quarter, exports declined 5.9 percent while imports surged 17.7 percent. This highlights the strength of the US economy relative to the rest of the world. It also can be attributed to the strength of dollar versus other currencies. When the dollar strengthens, our products become more expensive to foreign buyers and their products become cheaper for us. In our view, the economy is still doing fine.
The markets are trying to handicap how high rates are going to eventually go. We saw the markets rally 3 precent after being relieved to know the FOMC was not actively considering a 75-basis point increase at the June meeting, an idea which had been circulating recently. That said, significant swings in the stock market will likely continue to happen due to investor anxiety.
It looks as though the markets have already priced in a Fed Funds rate of 2.75 – 3 percent based on current valuations and anticipated earnings growth for 2022. Unless rates expectations move higher, or earnings growth turns negative, the stock and bond markets have reached or are near their lows. Unfortunately, when markets correct, they usually go too far. We can expect markets to remain volatile.
- Do you think inflation will slow down in 2022 – or will it remain high due to the Russia-Ukraine war, the ongoing labor shortage and supply chain issues?
Inflation began to accelerate in the second half of 2021, with prices as measured by the Consumer Price Index rising six percent during that time. This coincided with the reopening of the economy. As restrictions began to be lifted, consumers returned to normal activities. At the same time, supply chains which were dramatically impacted by the pandemic, continued to be in disarray resulting in shortages. But it’s important to remember that those months were some of the lowest inflation readings in 2020. The average inflation rate for 2020 and 2021 was only 2.9 percent. The year over year comparisons will be more difficult in 2022. For example, it’s hard to see used car prices rise forty percent again this year like they did in 2021.
A basic economic principle is that too much demand and too little supply equals higher prices. Fortunately, both demand pressures and supply shortages should abate as the year goes on and prices will begin to stabilize resulting in lower rates of inflation. Higher prices by themselves will limit inflation in two ways. First, they provide an incentive for producers to make more, thereby increasing supply. Second, they have the effect of crimping demand. This will hold true for everything from new home construction to auto production to crop planting and oil drilling. It will just take some time.
For all the talk about labor shortages, the Employment Cost Index rose four percent in 2021. In the past few months, we’ve begun to see labor demand cool off. The average workweek declined 1.4 percent in January. Unlike the 1970’s, the threat of a wage-price spiral is not a concern right now. Some wage inflation is good for the economy as it supports consumption.
- Inflation and the higher costs that follow often prompt fear of an economy that’s in trouble. Do you see it that way?
A wage price spiral, where higher prices prompt companies to raise wages for workers which then results in even higher prices for both consumers and businesses, is not likely. As we’ve seen already, wage growth is not keeping up with inflation and consumers are having to dip into savings, increase the use of credit, or cut back on spending. We’ve noted before that demand destruction is one of the cures for inflation. We’re more concerned about a policy mistake by the Fed.
Chairman Powell has recently spoken of his admiration of Paul Volcker, the former Fed chairman credited with taming the inflation of the 70’s through aggressive rate increases. Many are interpreting this to mean that the Fed may be willing to let the economy go into recession if that is what’s necessary to tame inflation.
While the markets are placing a great deal of faith in the Fed, and their chances of engineering a ‘soft landing,’ history would suggest that their ability to forecast, much less direct where the economy is going is somewhat limited. Too many things are outside their control as we’ve seen .already this year. The Fed uses blunt instruments not surgical tools.
- People have seen extraordinarily high returns in their retirement portfolios in the past couple of years. But four months into 2022, the market has seen a broad spectrum drop in value. How do you see things playing out this year?
We’re entering a different investment environment and the markets will need to adjust. We’ve had two-plus years of ultra-low interest rates and extreme levels of monetary and fiscal stimulus. That helped to mitigate the effects of the pandemic, but also boosted asset prices. We see it in stocks, housing, cryptocurrencies, you name it.
We have already seen the savings rate drop as people have worked through the last of their stimulus checks and unemployment benefits. Now, with rates on the rise, stock valuations are under pressure. We think stocks can still go up from here, but the gains will be more modest going forward. Most investors are okay with that. They fear going backward. That’s not likely unless the Fed goes too far, and we end up heading into a recession.
As noted earlier, we think the markets have already priced in many of the rate increases already planned for 2022. This is being reflected in the decline in stock valuations. The forward P/E for the S&P 500 now stands at 18.4 versus 21 at the beginning of the year. This decline in valuation explains all the markets losses year to date, as earnings have continued to grow. For the first quarter, earnings are on track to grow more than 8 percent from a year ago. Ultimately, this is what matters.
However, markets are like a pendulum and rarely stop at fair value. They swing between overvalued and undervalued. The greater the level of uncertainty, the wider the swings. We are currently in a period of heightened uncertainty but expect more clarity as the year goes on.
- Are there investment sectors like technology or energy that historically perform better during higher inflation periods?
Commodities like energy and materials do best during periods of modest inflation. Too much inflation hurts them too because it causes demand destruction. In other words, if the price of something goes up too far, consumers will look for substitutes or defer purchases altogether.
Financials do well when the Fed is raising rates, particularly if it causes the yield curve to steepen. Lately, however, we’ve begun to see the yield curve flatten with the difference between 2-year and 10-year treasury yields falling to 0.49 percent. That can be a sign the bond market believes growth will slow down. Real estate is another sector than can tolerate higher inflation.
Technology and high valuation stocks in general struggle. Higher inflation means higher interest rates. Higher interest rates reduce the value of future earnings making them worth less today. The market tends to overshoot in both directions. This may create a good long-term investment opportunity.
- What about newer investments such as cryptocurrency and NFTs – are these potentially attractive opportunities during higher inflation?
It’s too early to tell. We’ve heard them described as hedges against inflation and stock market volatility, but when you look at their price movement, they tend to behave like stocks. It’s also important to remember that not all cryptocurrencies are created equal. There appears to be a lot of speculation going on in those markets. We’re trying to see where they fit within the construct of a diversified portfolio.
Steve Doorn, CFA
Director of Portfolio Management