October Investment Comments
In the wake of lockdowns and restrictions that throttled the services sector, the U.S. economy in 2022 needs to return to form without aid from the fiscal and monetary stimulus that carried many consumers and businesses through the pandemic. The data has been volatile and sometimes contradictory. GDP contracted -0.6% in the second quarter, markedly better than the first quarter’s revised change of -1.6%. Unemployment ticked higher to 3.7% in August, but for the best possible reason—employers hired at a rapid pace while workers came off the sidelines and returned to the workforce even faster. Labor force participation has remained stubbornly below its pre-pandemic average, causing fears of a permanently lower equilibrium. Those fears may be overblown.
Inflation has slowed thanks to retreating energy prices. After a flat July, August’s CPI report showed a 0.1% month-over-month increase. The uptick dashed hopes that the CPI would politely roll over and recede back to its old normal. Energy declined 5% month-over-month but remains up 24% in the last twelve months. Food costs rose 0.8% and are up more than 11% in the last twelve months, their fastest annual increase since May 1979. Core inflation outside of energy and food was 6.3% for the 12 months ending August. The report all but ensures another 0.75% interest rate increase at the next Federal Reserve meeting. Interest rates rose and stocks fell. The U.S. dollar strengthened apace.
The Fed is in a bind of its own making after waiting a full year to start responding to the inflation statistics that first perked up in May of 2020.
Imagine the following. You are driving toward a stoplight. There is a line of stopped cars, but you are still a long way away, and instinct tells you that by the time you get there the cars will have accelerated and gone through the light. You keep speeding toward the light, but the cars do not move. Maybe the light was a long one. Maybe the driver in front was slow to react. Maybe the line was longer than you estimated. You slam on your brakes late to avoid a collision. How embarrassing! Now you have to hope the cars behind you have time to stop as well, for their own sake and yours. Why didn’t you simply slow down when you first saw the line ahead? So it has been with the Federal Reserve applying the brakes too late after inflation failed to resolve itself as the Fed hoped.
Now the Fed has to raise interest rates rapidly to hold back inflation, with the risk of causing damage in its wake. The Federal Funds rate is currently at 2.5% and expected to rise to 4% by the end of the year. That is well below the trailing rate of core CPI inflation but is slightly above median expectations for 3-year forward inflation, according to a survey by the Federal Reserve Bank of New York. By that measure, short-term rates would be approximately neutral, meaning further hikes in 2023 would be, in theory, restrictive. Forward inflation expectations are volatile and can change based on factors that are hard to model, the hardest being the Fed’s unknown future responses to changing data. As with August’s CPI report, if inflation expectations prove inaccurate, then most of the risk is probably to the upside. The Fed claims it is committed to keeping inflation low, and in 2022 its actions have been mostly consistent with that claim. If its progress has been a little slow then one excuse could be a simple lack of practice. The last time the Fed Funds rate was this high and still rising was way back in 2005.
For better or worse, delaying the return to neutral interest rates prevented the U.S. from straying too far from the ultra-dovish policies of our trading partners. It is hard to find any major foreign central bank demonstrating a real interest in fighting inflation. The Bank of England has slightly lagged the U.S. Federal Reserve despite experiencing inflation about 2% higher. The Eurozone has seen even higher inflation, but the European Central Bank waited until September 8th to hike its overnight deposit rate for the first time from 0 to 0.75%. Japanese short-term rates remain negative. Inflation is only about 3% there, but that is high relative to recent decades. This is Japan’s highest inflation since the early 1990’s, and it is rising.
The U.S. dollar’s strength reflects the Federal Reserve’s relative hawkishness. The dollar is up about 30% against the yen and recently crossed “parity” with the euro for the first time in twenty years, meaning one dollar became more valuable than one euro. Arguably, parity is merely a psychological concept. The euro going from $1.01 to $0.99 is not intrinsically different from going from $1.07 to $1.05. Psychology has meaning though, and it may not be a coincidence that the ECB was finally motivated to start raising rates after its currency crossed a key psychological threshold.
Speaking of Europe, boycotts of Russian energy are causing alarming spikes in fuel and electricity prices. As cold weather approaches, it will become more difficult to balance rising demand against scarce supplies. The solution looks like a combination of maximizing liquified natural gas imports, increasing nuclear power generation, and reducing industrial electricity demand, meaning a possibly severe recession. This delicate position leaves Europe very fragile. The optimistic view is that energy policy should adapt with time, and until it does, Europe can probably fall back on the slightly humiliating option to bargain with Russia to restore its gas supply.
The U.S. is relatively lucky that its primary economic concern right now is simply balancing the risk of inflation against the risk of recession. A little of either, or a little of both, should not be cause for grave concern. Most other major economies seem destined for both, to the point where “contagion” becomes a salient risk for the U.S.—that is, the risk that international weakness spills over. Again, however, the good news is that when you are worried about contagion, that means the center of weakness is somewhere else.
It is a good time to remember that stocks are real assets, backed by the value of the business operations they represent. Fundamentally, it does not matter what currency those businesses keep their accounts in. Inflation harms stock returns through the secondary pathway of higher rates. Bonds offer no inflation protection. As always, we preach the merits of growing, high-quality companies. When you build a portfolio around equity in solid businesses, at least you know where you stand, whatever central banks are up to.
Miles Putnam, CFA