Inflation Fears, Recession Fears, Rising Stock Market

The first half of the year was marred by inflation fears, this past month recession fears have been the headlines, and yet now markets are moving higher. Our discussion of inflation and the role of the Fed has been well documented. Inflation ruled the day over these past six-plus months and the Federal Reserve has been acting swiftly (and playing catch up) to squash it. The CPI numbers that measure inflation are lagging indicators and still show rising inflation, but the forward-looking numbers like commodity prices (especially gas) and business growth (measured by revenue) are coming down significantly. Oil and other commodities peaked in early June, and of these companies – Google, Tesla, Microsoft, Netflix, Amazon, Apple, and Facebook – all are growing at their slowest pace since 2019 or in Netflix and Facebook’s cases, slowest since 2012 and company history, respectively. On top of that, GDP growth has been negative over the past two quarters meeting a classical definition of recession. Note that recessions are also good ways to curb inflation, even though that’s not what anybody wants. So, why are the markets up roughly 15% from their lows? Markets are forward-looking and they are predicting that interest rates have peaked, and growth will continue even if it is slow.

The simple definition of a recession being two consecutive quarters of contraction does not give the full picture. For most people, a recession shows up in their daily lives through job losses, business closings, and bankruptcies. But as we look around, that is not what we see. Job growth remains strong, with millions of excess job openings available, and voluntary quit rates are still at all-time highs. Consumer spending is still growing, and business investment is unchanged from a year ago. And if you look at GDP from a year ago instead of relative to last quarter you also still see growth. Slower growth, but growth, nonetheless. This is what the market is pricing in.

To summarize, massive stimulus during the pandemic along with supply chain disruption from COVID and war caused a huge inflation spike, the markets and the Fed freaked out and made efforts to remove cash from the economy and thus caused economic slowdown/contraction. Now the markets are looking ahead to lower inflation and moderating growth and bidding stock prices higher again. It will be a choppy second half of the year, but history tells us the risk/reward of investing during this part of the economic cycle favors taking the risk.

Green Shoots

We finally saw some green on our screens last week after seven consecutive weeks of declines. The question is, were these the green shoots of new growth or just another head fake from this grinding bear market? The negative sentiment in the market has been substantial as seemingly everywhere we look we see financial pain – with increasing prices on food and fuel, new and used cars, airlines and travel, and continued supply bottlenecks due to war and shipping disruptions. When sentiment gets overwhelmingly negative it eventually becomes exhausting and the selling can quickly dry up. At this point buyers step back in. During a bear market you can see this cycle take place many times before the ultimate bottom. But trying to predict which specific rally is the true beginning of the next bull market and which one is just a head fake is a fool’s errand.  As long-term investors we are buyers on the way up and the way down and try to capture the most value along the way. That means rotating from overvalued sectors to undervalued ones rather than outright selling and moving to cash for prolonged periods of time jumping in and out of trades. Too many investors will make the devastating mistake of getting overconfident and trying to become traders during bull markets as everything is going up only to see their trades wiped out during a bear market and then feel the urge to sell not just losing trades but quality holdings as well, for “peace of mind”.

The rally we saw last week was most likely a result of more than just a break from relentless selling. The big metric all traders are focused on is inflation. And last week the Fed’s preferred inflation metric, the Core Personal Consumption Expenditure (PCE), showed signs of easing inflationary pressure. The figure came in at 4.9%, down from 5.2% the previous month. The markets reacted positively to the news since it raises the possibility that the Fed may be able to moderate its rate hikes if inflation continues to come down.

Consider this example on how raising interest rates by the Fed works its way through the economy and decreases spending power and ultimately demand for goods.

Today the median home price is 6.7x higher than median household income. Homes have never been more unaffordable - the Fed is aware and wants to moderate home price inflation. Raising interest rates will accomplish this. Furthermore, the Fed understands this action will moderate inflation more broadly as well. In Jan 2021 the cost of a 30-year mortgage was 2.65%. At that time the average home price was $401,700. Today a 30-year mortgage is 5.25% and the average home price is $570,000. That is a 95% increase in monthly payment from $1,294 to $2,519.

The cost of living in a home (for new buyers) essentially doubled in that time frame. All those extra dollars that would have flown through into the economy to be spent on gadgets, and clothes, and travel and whatever else will now be sucked up by banks rather than chasing goods and services.

All About the Benjamins

The Fed more than any other factor is driving this market. They control the money supply and cash is king right now. Markets rallied on April 28th after GDP numbers showed the economy contracted in the first quarter by 1.4%. Economists were expecting a 1% gain. Why did stocks go up as the economy contracted? The Fed. If the economy is not growing, then the Federal Reserve will have less incentive to raise interest rates and decrease the supply of money. More money available to grow your business and buy stocks equals higher stock prices (and other prices). Inflation must be combatted but it is unlikely that the Fed will do so at the expense of growth and jobs.

Given this reality, news and global events are all noise unless they push the Fed narrative further in one direction or the other. The Ukraine war, high inflation, and slowing earnings growth are all baked into market expectations at this point. The markets are already pricing in interest rate hikes up to 2.75% by year end (we stand at 0.5% today). Due to this dynamic with interest rates (at least in the near term), the worse things get economically the better the markets might perform.

As rates have risen this year, we have a seen pretty significant rotation out of growth stocks and into non-cyclical sectors like energy, materials, real estate, and consumer staples stocks. These “defensive” stocks typically have less volatility, trade at lower price to earnings multiples, and are less dependent on low interest rates. However, if we see the economy slow and rate hike expectations come down meaningfully, we will most likely get a reversal back into growth names (like Google, Tesla, etc). We advocate holding a portfolio with a balance between defensive and offensive stocks. While some people may get lucky holding concentrated positions that go to the moon, most of the time this doesn’t work out.

As we have seen over these past 25 months markets can change very quickly, and the punishment can be brutal. We have seen pandemic play darlings like DraftKings, Zoom, and Teladoc (and many, many others) decline 80% or more. Large-scale market declines like this have not been seen since the tech bubble burst in 2000-2001. We are still sifting though the current carnage to find the names that will emerge as winners (as Apple and Microsoft did following the tech bubble), but in the meantime it is prudent to steadily invest in a diversified basket of securities so your savings can overcome the erosion of inflation.

Market Update - Q1 2022

The first quarter this year has so far been marred by war, oil price shocks, inflation, and rising interest rates. As it stands now, the Dow and S&P 500 indices have each fallen about 4% this year, while the tech-heavy Nasdaq index has fallen 8%. Yet, the markets have rallied strongly off their bottoms. The Dow is up about 8% from its low, and the S&P 500 and Nasdaq are up 15% and 16% from their lows, respectively. It goes to show that trying to time the market can be very difficult. In the age of fast internet access and the ability of traders to trade from anywhere, market moves are happening quicker than ever. Just as everything seemed to be at its worst in terms of geopolitics and economics markets started rapidly recovering.

War and surplus cash have pushed oil and other commodity prices soaring over the past three months. This has compelled the White House to announce that the US would be tapping its “strategic reserves” of oil in order to add supply to the market and help ease the upward pressure on price. The reaction of the oil markets were swift and crude prices immediately fell by nearly 10%. Still, year-to-date oil prices are up over 35% and we are all feeling it at the pump. Further price declines from here along with easing of tensions in Eastern Europe should help moderate inflation somewhat as commodities (and goods made from those commodities) flow more smoothly.

Unfortunately, inflation remains a concern for both consumers and the Federal Reserve, who is mandated to maintain price stability and full employment. As of now, the markets are pricing in 8 interest rate increases in 2022. That would mean the Fed would be increasing rates every month on average. Anyone who has recently looked to buy a home or refinance has seen rates jump considerably since last year. However, this is not all doom and gloom. Rates are still very low by historical standards and any deviation away from aggressive rate increases will be greatly cheered on by the equity markets.

As we head into Q2 we anticipate less volatility than we saw this past three months and still maintain a strong bias to equities versus fixed income.

Russia, Ukraine, and the Markets

Firstly, across all investment portfolios that we manage, we have no direct investments in companies located in either the Ukraine or Russia. That said, economic ramifications will reverberate around the globe, so it is a priority for HWM to stay apprised and analyze the current events as they effect securities everywhere.

The US and EU along with other Western powers in the financial world have placed severe sanctions on the Russian economy and some of its wealthy oligarchs. Even the Swiss jumped in and announced they will be freezing assets. The major economic development so far has been the cutting off of Russian banks from SWIFT, the international banking communication system. US Intelligence states that Putin has been building a war chest since 2014 while reducing national debt. Their reserves currently stand at roughly $640 billion in foreign assets. Nevertheless, war is straining the Russian economy and citizens are already feeling the pain in terms of inflation and cross boarder capital restrictions. The ruble tumbled over 30% and had its largest one day drop in history on Monday. In order to combat inflation and stymie further erosion of the currency, the Russian central bank pushed interest rates up to 20% from 9.5%. This along with SWIFT actions have caused Sperbank (Russia’s largest bank) and other Russian banks serious liquidity issues and is pushing them to the brink of failure. It is difficult to determine just how much exposure key financial entities have to Russian banks and assets, but it has been reported that for S&P 500 companies only 0.1% of their sales come from Russian customers. It is also important to point out that paying for oil and gas is currently exempt from the SWIFT sanctions. Reasons being, Western Europe needs its energy and equally if not more importantly commodity markets (prices and availability) in general must remain relatively stable lest the entire industrial-financial complex experience severe shocks.

What does this mean for our market positioning? Let’s examine three scenarios: the bad, the terrible, and the most likely.

In the bad scenario, fighting draws out longer, more foreign aid is poured into Ukraine, Putin ramps up nuclear threat language, China increases support and even advances it war aims in Taiwan, and supply chains get constrained. In the terrible scenario, both Russia and China engage in full scale war in their theatres, Russia initiates preparations to deploy nuclear missiles aimed at any country that threatens its advances in Ukraine. Runs on banks and global panic ensues. Hopefully those two scenarios don’t play out. In the most likely (and better) scenario, battling continues, Russia surrounds and takes Kyiv, installs a pro-Russian government, and refrains from further hostilities for the time being. In the US, talk returns to inflation and Fed.

In all three of these cases, it stands to reason that the Fed would be less aggressive going forward. But regardless of Fed actions we would look to raise some cash in the first scenario, and aggressively in the second (looking for stores of value like gold). In the meantime, we are still cautiously optimistic and see risk assets (stocks) as better investment options than cash. We like growth over value in the long run but could see value continue to outperform in the near-term as investors seek the comfort of dividends.

Economic Resiliency

Time to buy, sell, or wait? Among war, inflation, interest rate hikes, congressional gridlock, and everything else, what do we do as investors? Short answer – buy or wait. The fear gauge, VIX, is at levels not seen since the early days of the pandemic and the “taper tantrum” of 2018 before that (when the Fed started tightening the last time). In those instances, over the following 6 months the markets rallied around 40% and 16%, respectively.

The biggest losers in this current drawdown have been high growth tech companies and recent IPOs. Software companies are down about 25%, stocks that came to market in the last 2-3 years (IPOs) are down 38%, and ultra-high growth/new technology companies are down over 50%. In this segment of the market, this is more than a market correction, this is a market crash. Granted many of these stocks did not deserve the valuation they were trading at, so crashing from their dizzying heights was justified – an unprofitable exercise bike company worth more than Ford? But, just as always happens the baby gets thrown out with the bathwater. Quality companies booking solid profits like Salesforce, Netflix, Zoom, Twitter, Shopify, and Facebook have seen their stock prices cut in half despite onboarding millions more users, increasing revenues, and in many cases increasing their brands and market dominance.

An investor with long-term growth goals should be looking at buying companies and sectors that are solidly growing earnings and will be leaders of the future economy. Over the past few months, the only trades that seem to have worked have been in the energy sector (as oil and gas prices have risen – most likely from inflation and geopolitics). However, over the next year or two, or beyond, who do you think will grow earnings and innovation faster, a company like Chevron or one like Apple? I think the answer is obvious, yet Chevron is up over 36% since December and Apple is down 10%. Sector rotations and choppiness are normal in the short term, but macro trends persist and typically win-out over longer timescales.

Fear is very high right now, but the economy remains strong and resilient. And as economies and companies grow so do their share prices in general. Consumers make up 70% of US GDP and the most recent reports showed spending increased at its fastest pace in ten months. This comes at a time when inflation was at 40-year highs with fuel prices soaring, wages stagnated, investment portfolios were declining, and war was looming. It’s going to take more than fears of Fed rate hikes and geopolitical maneuvering to drive this economy into a recession. The recent choppiness in the market looks at the very least like a “wait and see” moment, if not a buying opportunity.

A Look Back and Look Ahead

It was another strong year for equities in 2021 with the S&P and Nasdaq each advancing around 27% and the Dow 19%. Much of the rise came as a result of a very accommodative Fed that continued to pump record amounts of cash into the economy and investor optimism over vaccine and therapeutic developments to combat COVID. But not all was rosy in the economy as consumers experienced the highest levels of inflation since 1982 and global trade bottlenecks crimped supply of goods the world over.

In 2020, consumers were stuck at home and not spending. Their savings accounts rose as did their appetites for new entertaining consumer goods and desires to upgrade current gadgets. Yet at the same time factories and ports were shutting down operations in major trade hubs as governments and employers tried their best to contain COVID outbreaks. The result was inflation.

Supply was limited just as demand for goods skyrocketed. Prices for container space jumped, increasing costs on everything from paper products and electronics to oil and gas. However, the worst may be over. Inflation most likely already peaked and will be returning to a normal range by year end 2022. Goods are presently flowing much smoother than just a few months ago and we’ve seen commodity prices recede from their highs earlier this year - a major driver of inflation. And as inflation abates, the Fed most likely won’t be so swift to raise rates as they previously stated was their intention for the coming year.

Twenty twenty-two is poised to be another tricky year as businesses try to navigate pandemic disruptions, but it should bring with it continued economic expansion with investment returns moderating relative to the last two years, but growing nonetheless.

Taxes and Stock Market

Stocks are ending the week roughly flat after seesawing and selling off on capital gains tax fears on Thursday. For those worried that they will be paying higher taxes, rest assured only the very wealthy will be doing so. According to Bloomberg, a top rate of 39.6% would only apply to those with more than $1 million in annual income. Some investors may fear that with higher taxes there will be less investment in the stock market and thus create a market sell-off. Historically, this has not been the case. Reuters notes the following:

Consider that in 1981 the capital gains rate was cut significantly—from 28% to 20%. The S&P 500 fell 22% over the 12 months after the law was enacted. Then in 1987, the rates were changed, back up to 28%. The S&P rose significantly, but then dropped in the 1987 crash. In 1997, the rate was again cut down to 20%. The S&P 500 continued the bull market run it was already in. Then in 2003, the rate was cut again, down to 15%. Stocks dropped sharply in reaction to the announcement, but when the rate cut was actually enacted, stocks had begun a bull run.

At best it is indiscernible what effect capital gains tax has on the stock market. The most important factor remains staying invested for the long-haul and trying to look beyond the noise.

Market Volatility

Markets have been experiencing increased volatility since mid-February when interest rates began moving sharply higher. Stock investors are concerned that increased borrowing costs will put downward pressure on growth and threaten the solvency of some companies. Even if true, keep in mind that interest rates are still very, very low so the main concern is the uncertainty. How much higher will yields go and will added inflation force the Fed to raise rates driving yields ever higher? It is our contention that rate volatility will subside soon, and calm will return to the markets. The growth story for stocks is still in tack with rising GDP, economies reopening, and more fiscal stimulus on the way. We see further pull-backs as buying opportunities.

2021 Outlook

The story of 2020 and 2021 is (obviously) the virus. Simply speaking, the markets trade lower when the virus looks less contained and higher when it looks more contained. For this reason, and others stated below we are optimistic on stocks for 2021.

• The vaccines currently available have about a 95% protection rate and their rollout has been going relatively smoothly. The government hopes to have the majority of the population vaccinated by summer.

• Business and manufacturing sentiment are strong, and data suggests we are on a new cyclical upturn (as measured by corporate profits and cash flow). We should be at pre-Covid levels by late spring.

• Job confidence is rising with food service and leisure jobs projected to return robustly in the second half of 2021.

• Trade tensions will most likely ease, keeping a lid on inflation and enhancing consumer confidence.

• US growth in GDP is projected to be between 4 and 6%.

• Fiscal and monetary policy will remain loose, meaning there will be a large supply of cheap money, and treasury checks will be going out soon as a result of the latest stimulus package.

Conclusion:
For the stock market, we believe the risks to the economy in the form of evictions, restaurant and store closures, virus spikes, et cetera will be more than offset by the largest stimulus program in modern history (between Federal Reserve actions and congressional legislation). Even after this great run for stocks, valuations are still reasonable due to record low interest rates. Investments in bonds and cash simply don’t currently offer meaningful returns as they once did. Stocks have room to run.