The first half of 2022 was a brutal slog for investors with relatively few places to hide. Stocks and bonds simultaneously faced steep price declines amid extreme volatility. However, in July we witnessed a major turnaround in the stock markets and digital assets despite aggressive rate hikes and mounting evidence of a recession. Markets around the world bounced back, posting the best month since 2020. Moreover, July's headline and core CPI inflation rates were lower than expected, consistent with our view that inflation is peaking, but at 8.5%, still remains too high.
Overall, the reasons for financial market carnage in the first half of the year are well-known: the worst inflation in 40 years; an about-face turn in the Federal Reserve and central-bank monetary policies from extraordinary easing to the most restrictive settings; Putin’s invasion of Ukraine; and fears that China’s zero-COVID-19 policy will continue to disrupt not only its own economy but that of the world.
Federal Reserve (Fed) Chairman Jerome Powell still hopes that the central bank can achieve a soft landing for the U.S. economy, where inflation gradually decelerates back to the 2% target without a ‘true recession’. A mild recession appears to be in the cards, along the lines of the 2001 experience vs. a re-run of the GFC (great financial crisis). Evidence suggests that the U.S. economy may continue to show a resiliency that surprises both the Fed and investors. The labor market, for instance, remains exceptionally tight.
On July 27, 2022, Chairman Powell gave a press conference after the Federal Open Market Committee (FOMC) raised the target interest rate range by 0.75%. It is now 2.25% - 2.5%. Chairman Powell may believe the economy has turned a corner and is slowing down. Powell gently warned the public to expect some pain in the labor market and the economy in general before this bout of inflation can begin to subside. Powell described current interest rates as “neutral” which was a big surprise buoying equity markets.
Powell did not guide the markets as to how much the Fed might raise rates at their next meeting in September but did reiterate that they see rates between 3 and 3.5%. He gave a very wide latitude for the September meeting and said the Fed is now ‘data dependent’, apparently less robotic in their decision making and conditions are changing.
The Fed decision making today is a “pick one of two” dilemma. If the Fed optimizes for lowering inflation, then it must continue raising its policy rate, slowing the economy. One could argue the Fed needs to get even more aggressive, as its policy rate of 2.5% at the upper bound is still 6% below the latest 8.5% inflation reading. If the Fed optimizes for future growth, then it must ultimately cut its policy rate and start buying bonds to help reduce the burden of those making monthly payments for housing, autos, and other durable goods. At the moment, the market is currently pricing in a .75% hike in September and a subsequent pause at the November meeting.
So what else could hinder the Fed and their decision making? Zoltan Posza recently shared his latest big picture risk narrative, explaining we are entering an entirely different era, one in which Chairman Powell and global central bankers are increasingly irrelevant to much larger ‘stochastic’ forces at play:
“The low inflation world stood on three pillars: first, cheap immigrant labor keeping service sector wages stagnant in the US; second, cheap goods from China raising living standards amid stagnant wages; third, cheap Russian gas powering German industry and the EU more broadly.
“US consumers were soaking up all the cheap stuff the world had to offer: the asset rich, benefiting from decades of QE, bought high-end stuff from Europe produced using cheap Russian gas, and lower-income households bought all the cheap stuff coming from China. All this worked for decades until nativism, protectionism and geopolitics destabilized the low inflation world…
“Central banks went from waging a war against deflationary impulses coming from the globalization of cheap resources (labor, goods and commodities) to ‘cleaning up’ the inflationary impulses coming from a complex economic war.
“Think of the economic war between the US, China, and Russia as something that will weaken the pillars of the globalized, low inflation world described above – the process will be slow, not sudden, but it will be certain, where ongoing economic ‘tits’ for ‘tats’ will have the potential to drive more and more inflation.
“Think of the economic war as a fight between the consumer-driven West, where the level of demand has been maximized, and the production-driven East, where the level of supply has been maximized to meet the needs of the West… until East-West relations soured, and supply snapped back…
“The unfolding economic war between great powers is stochastic and not linear, and what inflation will do in the future depends not only on the shocks that occurred in the recent past, but also on the many shocks that can happen still. These include more sanctions and the further weaponization of commodities, and more technology sanctions and further supply chain issues for cheap goods.
“Getting right where inflation goes from here is basically a matter of perspective; do you see inflation as cyclical (a messy re-opening after COVID, exacerbated by excessive stimulus) or structural (a messy transition to a multipolar world order, where two great powers are challenging the might and hegemony of the US). If the former, inflation has peaked. If the latter, inflation has barely started.”
Zoltan’s full dispatch is available below. For now, while inflation and recession are the headline risks, we believe much of the damage has been done and markets are rebounding in a broad recovery. Of all the uncertainties facing investors today, the prediction game is ever more challenging, so we remain humble and nimble, believing a tactical and diversified approach to investing with prudent financial planning remains the best course for clients to achieve their financial goals.
If you have questions about your portfolio, have updates for your financial planning strategy, or would like to discuss the challenges and opportunities the current economic environment may present for your specific situation, please contact our team at 800-542-4916 at any time. As always, we enjoy working with you and wish you a healthy, happy summer.
Eric W. Kendrick, CFP