Highlights: 

· Faster than anticipated monetary tightening due to rapid inflation surprised investors and led to a sell-off in the global equity markets. 

· Central banks face an uphill battle to try to bring down inflation without triggering a recession. If we are in, or heading towards, a recession, it will be unique because employment remains strong.

· Investors would be best served to not rely on lax monetary policies going forward as they have for the last decade-plus. 

Commentary: 

“Is there a risk we would go too far? Certainly there’s a risk. The bigger mistake to make – let’s put it that way – would be to fail to restore price stability…There’s a clock running here. The risk is that because of the multiplicity of shocks, you start to transition into a higher-inflation regime. Our job is literally to prevent that from happening, and we will prevent that from happening.” 

-Federal Reserve Chairman Jerome Powell 

There are very few things investors dislike more than uncertainty. So when the U.S. Federal Reserve (“Fed”), indicated during the quarter that they planned a more rapid pace of tightening than previous expectations, investors reacted as expected and sold risk assets. The S&P 500 has fallen 20.6% over the first half of the year, marking the biggest decline in over 50 years.  

Higher rates translate to higher borrowing costs for credit cards, mortgages and auto loans, which should help cool demand as these higher rates are passed on by banks to households and businesses. This is likely to ease price pressures as wage growth attempts to keep up with rising prices, consumer demand slows, and the supply chain is better able to meet demand. Unlike the past rate hike cycles, there’s no obvious asset bubble to burst, like the housing market in 2007 or internet stocks in the late 1990s, to quickly bring down inflation. This is why the Fed, with U.S. inflation at a 40 year high, is acting aggressively at this time and is indicating it will continue in this direction until they see some dampening of inflation.   

Higher prices and borrowing rates already seem to be putting pressure on U.S. consumers. Household spending, the backbone of the economy, rose in May at the slowest rate this year. A slowdown in consumer spending is likely due to both higher inflation and interest rates, and the dwindling of approximately $2 trillion in excess savings that accumulated during the Covid-19 pandemic when spending fell and government stimulus embellished bank accounts.

Going forward, investors will be looking to see if central banks can somehow pull off a soft landing by controlling inflation and avoiding a sharp economic downturn, or if a recession is inevitable. Regardless, as the quote above shows, it has become clear that entrenched inflation, where consumers and businesses expect persistently higher prices, is currently the biggest perceived threat by the Fed to the economy. By aggressively raising rates now, the Fed will have more room to cut rates to fight a recession in the future. This is a luxury central banks have not had over the last decade. 

Elsewhere, the European Central Bank (“ECB”) plans to raise the bank’s key interest rates at their July and September policy meetings, but at a more gradual pace than the Fed because they want to gauge the economic fallout of the war in Ukraine. The conflict is driving up energy and commodity prices because Europe relies on imported energy from Russia and grain from Ukraine. In addition, the economic recovery has been slower and government spending more restrained in Europe as compared to the U.S. The ECB is also faced with the delicate task of tightening monetary policy to battle inflation without weakening the economies of its weakest member countries. 

On the other end of the spectrum, the Bank of Japan remains committed to a policy of monetary easing to support a local economy that is still in the earlier stages of recovery from the Covid-19 pandemic. While low rates encourage borrowing to help stimulate Japan’s economy, a weak yen means Japan needs to pay more for imported food and energy.  

Likewise, Covid-19 lockdowns hurt domestic demand in China, especially spending on travel and entertainment. This has led some economists to predict that China’s policy makers might increase stimulus to improve economic growth and employment. However, easing too aggressively risks capital fleeing China in search of higher yielding returns. 

Thus, every region of the globe has its unique economic challenges. While central bank policies can reduce consumer demand, government intervention may also be needed to boost the economy’s capacity to produce more goods and services, and increase workforce participation.  

If we are heading towards, or already in, a recession, it will not look like any other on record since World War II. Each of the 12 recessions since World War II has been characterized by contracting economic output and rising unemployment. Economic output is indeed falling today, but the jobless rate has actually fallen from 4% in December to 3.6% in June. For their part, the Fed is hoping that higher interest rates decelerate spending enough that companies slow down with hiring to fill current job vacancies, while avoiding layoffs.  

Consumers are the most pessimistic about the economy since the University of Michigan began conducting its Consumer Sentiment index in the 1950s. This is a bit perplexing as today’s economic conditions certainly don’t feel anywhere near as bad as the 1970s when cars waited hours for fuel, or the 1980s when inflation was in the double digits and unemployment was double the current level, or 2008 when the global banking system teetered on the brink of collapse. Nevertheless, the danger is this becomes a self-fulfilling prophecy, and consumers, worried about the economy and their personal finances, cut back on spending, which then brings on a recession.  

If that were to come to fruition, many investors believe that recessions can actually have some healthy effects because recessions can tend to shift companies’ focus from growth to operations. Prolonged high growth is not always healthy because it creates many inefficiencies and inflates corporate cost structures.

After over a decade of global monetary expansion, capped by the pandemic period, it seems many investors have forgotten about cycles. We know that historically every bear market eventually finds its bottom and leads to a new economic cycle that brings even higher stock prices. If there is one thing investors should take away from the Covid-19 pandemic, it is that equity markets are forward-looking mechanisms. Recall that stocks rallied aggressively during some of the worst months of the pandemic because investors had already started to price in a strong economic recovery.  

After over a decade of ultra-accommodative monetary policy creating a rising tide that floated all boats, it appears we have entered a new cycle in which some industries and companies will perform well while others will not. Accordingly, we do not think investors should expect a V-Shaped recovery (sharp decline followed by a sharp rally) like the bull markets that followed the Covid-19 pandemic in 2020 or the financial crisis in 2009. This is because the Fed likely will not be available to come to the rescue so long as their efforts are focused on combating inflation. Most studies indicate that monetary policy takes about two years to have its intended effect on the economy. This suggests that today’s inflation might have been at least partially triggered by central bank stimulus in the early months of the pandemic. It also suggests that it might be a while before inflation returns to the Fed’s target rate of 2%. 

Nobody enjoys watching their portfolio go down, ourselves included, but the reality is that today’s declines are the price of admission for future return premiums. We remain committed to a long-term investment policy with an emphasis on insulating your portfolio with less volatile cash and fixed income investments to meet your personal anticipated withdrawal requirements over approximately the next nine years. We are confident that this cash flow-driven approach enables investors to realize the strongest and most sustainable portfolio returns over the longest period. This is one of, if not the, most critical elements of successful long-term investing. To quote legendary investor Jack Bogle, “your success in investing will depend in part on your character and guts and in part on your ability to realize, at the height of ebullience and the depth of despair alike, that this too, shall pass.” 

Urban Financial Advisory Corporation – July 2022