Domestic growth continues to be strong. Since our economy is very diverse, growth can be categorized in many ways. Some are growing off the charts (commodities), some are growing at normal rates (consumer staples and consumer discretionaries) and some are continuing to gain market share and be even more irreplaceable than they were before the pandemic (Big-Cap technology). What I am going to try and explain today is inflation- what it really means and although generally thought of as a nasty and undesirable situation, if happening on a gradual basis, it can be a good thing. I will also talk about the Fed and the growth rate of the economy- given the tools that we are most familiar with that the Fed has, it is often difficult to believe that they can raise rates but not cause a recession or a mild slow down. The third and most important point I would like to cover is the financial storm that is brewing outside the US that is being catalyzed by the Russian conflict.
One key thing that everyone needs to understand is that inflation by itself does not take down markets. What takes down stock prices is slower growth of the economy and lower profitability for the companies themselves. This then translates into consumer habits changing due to these price changes. Consumer behaviors of purchasing change and lifestyles are altered and therefore industries either flourish or consumption slows.
Inflation, as a term, is a political lightning rod. The media will choose to use the CPI (consumer price index) as a measuring stick for current inflation. Current CPI is up 7.9% versus a year ago and is expected to peak somewhere in the 8-9% range- the highest since 1981. The natural inference is that since inflation measures are now at 1981 levels that interest rates should be moving to 1981 levels as well. This is just not true! The politicians blame it on war or COVID, but the simple explanation is that there is just so much cash out there that consumers are able to pay massively elevated prices with the excess cash they have on hand. Three of the easiest components to understand the price changes on are food, gasoline, and used car prices. All consumers at all financial levels can get an emotional feel for these three—whether they are deeply affected or not. What I mean by this is a wealthy person may be able to afford $6.50 per gallon gas prices but are really upset that they have to pay it, and a lower income earner now has difficulty paying for other living expenses when paying this much for gas and is expectedly upset!
What isn't being discussed is that if food prices go super high, the world just produces more. If gasoline goes too high, producers find somewhere else to get it (Europe coming to the US for natural gas due to Russian embargos) or they change to a different type of fuel. And as for used cars, as soon as there is some level of stabilization in the supply chain, auto inventories should be replenished, and prices should normalize. The Russian / Ukraine conflict, coupled with more waves of the virus, is influencing prices and therefore consumption. This then diminishes the growth of consumption and a resulting slowdown in GDP. In Barron's this past weekend, there was an article about labor. In the article, it was said that many people are returning to the workforce because they are simply too bored with sitting around all day. Is it this or the fact that the government is no longer paying them to do nothing? Whichever it is, the fact remains that many that dropped out of the workforce during the pandemic are now returning.
I believe the ultimate indicator of the future course of inflation could be partially determined by the direction of the equity markets. Since equities prices are dependent on the expectation of future earnings, it is no wonder that the S&P 500 has been in a funk since the second half of 2021. Yet inflation measures weren't highly elevated yet even though prices started to decline. Since stock prices are a discounting mechanism where prices "today" reflect what is "expected" 9-12 months forward, it is no wonder that we are experiencing issues in many industries now, yet the price levels of these companies were declining many months ago. Now, as the supply chain begins to get back on course, equity prices are stabilizing and rising before the consumption numbers are even starting to improve. THIS IS AN INCREDIBLY DIFFICULT CONCEPT TO REMEMBER. We are so focused on the here and now, we have trouble considering the concept of time.
At this point in the cycle, Fed tightening is normal. This is the opposite of March 2020, when the world was within a hair’s breadth of a depression. The Fed injected an unprecedented amount of liquidity into the system and the administration poured tens of trillions of dollars into the so-called "infrastructure" bill. As the economy got back its footing, however, there is no need for additional stimulus.
Even though interest rates will rise today, the system remains very liquid as corporations, institutions, and individuals are still flushed with cash. As interest rates rise, this brings us to the current "fear de jour," the widely feared INVERTED YIELD CURVE. The media will have you believe that the inverted yield curve is when short rates are higher than long rates. The periods they are using to measure this inversion are the 2yr. to the 10yr. or the 5yr. to the 10yr. The reality is that the true measure—the one that is the most accurate at forecasting—is the 13-week T-bill yield to the 30-year Treasury. At this point, this comparison is a long way from inverting yet the 2 to 10 is getting close- perfect fodder for the media. When the 13-week to the 10 year is inverted, caution would then be warranted. Please take a moment and look at the two charts below that show the 2 to 10 relationship:
The first table is the picture of the 2yr vs the 10yr going back to the 1980s and the period of time before a recession actually occurred. The second one is a true timeline in a picture, of when things got difficult vs. when the inversion occurred. The difference this time, I believe is Jerome Powell. He has been very good at stating his intentions way ahead of time and in so doing allowed financial markets to adjust prior to the action being taken. Remember, he told us back in October & November of last year when he was going to turn off the money spigot and when he was going to begin to raise short rates. This was very good at providing stability in the financial markets. I believe that the non-farm payroll number we are expecting this Friday should give us some additional insights as to the continued velocity of economic growth (or lack thereof) and therefore the need or lack thereof for more drastic interest rate hikes. Powell will be sure to comment on this number as labor, he has stated, is very important to his decisions.
FINANCIAL STORM BREWING IN EUROPE
In the March 19th issue of Barron's, there was an interview with Louis-Vincent Gave, co-founder of Gavekal Research, “A Financial Storm Is Brewing in Europe. Where to Hide.” Gave uses terms like de-globalization and depression, but what is really important is what is happening in Europe due to the escalation in energy and agricultural commodity prices and the fact that Europe has basically run out of ways to mitigate the negative effects of these price hikes. There are many countries in continental Europe that remain in negative interest rate debacles or are close. At the same time, the strongest economy in Europe; Germany, has done something few are familiar with. They have all but done away with their nuclear power generation (which could arguably offer the best energy option by providing large-scale power production without emitting the feared greenhouse gases). Michael Shellenberger wrote emphatically in, "The West's Green Delusions Empowered Putin," written March 1, 2022. According to Shellenberger:
- While Putin expanded Russia's oil production, expanded natural gas production, and then doubled nuclear energy production to allow more exports of its precious gas, Europe, led by Germany, shut down its nuclear power plants, closed gas fields, and refused to develop more through advanced methods like fracking.
- The numbers tell the story best. In 2016, 30% of the natural gas consumed by the European Union came from Russia. In 2018, that figure jumped to 40%. By 2020, it was nearly 445, and by early 2021, it was nearly 47%.
Where do all of the commodities of Russia and Ukraine go? See below:
Shellenberger asserts- and it seems credible- that Europe allowed its dependence on imports of energy and other commodities, especially from Russia, to increase so dramatically because it wanted to be more ecologically responsible at home (sound familiar with what the current administration did with drilling in the US the first week of their administration!!!). In addition to limiting their production of oil and gas, some nations (especially Germany) reduced their use of nuclear power generation- which could arguably offer the best energy option by providing large-scale power production without emitting greenhouse gases- in a concession to those who consider nuclear power unsafe. He goes on to say:
- At the turn of the millennium, Germany's electricity was around 30% nuclear. But Germany has been sacking its reliable, inexpensive nuclear plants... By 2020, Germany had reduced its nuclear share from 30% to 11%. Then, on the last day of 2021, Germany shut down half of its remaining six nuclear reactors. The other three are slated for a shutdown at the end of the year.
The ultimate point is that energy is clearly the biggest commodity component, but with Ukraine being the "Breadbasket of Europe" agricultural commodities are also very important and are in the same turmoil. Above I referenced the interview with Gave in Barron's. Gave was asked, how do you see this potential crisis playing out? He was very succinct at saying that Europe's economic growth will collapse. "Over the next six months, inflation that continues to rise will lead to popular discontent. In the fall, Europe may see a massive surge in immigration, similar to the one that followed the Arab Spring, as the surge in wheat prices will create further political instability in the southern and eastern sides of the Mediterranean. Rising inflation plus surging immigration will boost the vote of the populist parties, which will be visible in the Spanish and Italian elections in 2023. While clouds hang over Europe, I wouldn't be inclined to add risk. You need to see the European situation stabilized." Please make sure that you follow what is going on in Europe. You will begin to hear the term “deglobalization.”
In closing, the energy situation has emerged due to the US mothballing many of our drilling locations and Germany focusing (shortsightedly) on overly environmental issues, at the expense of global economies. The follow-on is the increased costs due to skyrocketing agriculture prices. Europe, which is still deep in its COVID malaise, is clearly the worst affected. The US has the means and the growth in our domestic economy to rise above these issues. These increases in price levels should cause the level of GDP growth to be tempered and in so doing allow Powell & Co. to not increase rates at a speed that could throw us into a recession. The result is our domestic energy companies should continue to thrive, our domestic agriculture companies should thrive, and our employment picture should remain buoyant and stable. I don't say this to be insensitive to what is unfolding in Europe, but as an investor, I wish to concentrate on where business is doing the best, and this remains stateside. Lastly, remember the picture of what normally happens in the Mid-Term year of a US Presidential cycle. See below. We have experienced a rough patch since the second half of 2021, and we are looking forward to the second half of 2022 and into the Pre-Election year of 2023. Please be invested accordingly.
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