Inflation, Invasion, Inversion, Oh My!

Spring 2022 Market & Economic Commentary

It may seem like there was nowhere to hide in Q1 of 2022. With inflation still running red hot, the capital markets finally moved off their dilution (and belief in the government’s misrepresentation) that inflation was just “transitory.” Instead of abating towards the end of 2021, inflation actually accelerated to levels not seen in more than two generations. As markets came to the reality that inflation was now a major challenge to the U.S. economy and the personal situations of most Americans, bond markets sold off sending yields and the cost of credit higher… much higher. With inflation and higher interest rates now accepted and the new norm by the investing public, stocks, especially those in the extremely valuation-rich growth indices sold off, with the S&P 500 touching correction territory (down 10%) in just the first month of the year. But we were just getting started with what would prove to be one of, if not the most, difficult market environment for broadly diversified investors in over four decades.

As markets began to adjust to the prospect of higher interest rates and equity markets recovered off their January lows, a new threat to the U.S and broader global economy raised its violent head. Russia, which had been amassing troops on the eastern Ukrainian boarder, didn’t just slip a toe over the line, as they had done in Crimea in 2014. On February 24, they launched a brutal and full-scale assault on the entirety of Ukraine, including its capital of Kyiv. Unlike the global response in 2014, the response from the U.S. and Europe was swift and extreme (no judgment intended). Russia was pounded with financial sanctions and restrictions that some critics (including Russia itself) labelled an economic act of war.

By February 28th, Russian stocks were halted on global markets (many of which have yet to resume trading). Shortly thereafter, major U.S. brands like Coke, McDonald’s, and Starbucks were shuttering and devesting of all their Russian investments. Seemingly with the flip of a switch, the Cold War was back with full force. However, the pain wasn’t just felt in Moscow, with Russia as a major global supplier of oil and natural gas, as well as wheat and potash, commodity prices spiked from their already elevated levels, further exacerbating inflation pressures. Further, with Russian stocks frozen, along with the impacted assets of their global shareholders, many investors’ knee-jerk reactions were to sell their emerging market investments, especially those in Asia. After all, couldn’t China be next? After decades of feeling we were all playing by the same rules (more or less), international investing was again not just a game of earnings and P/Es, one now had to factor sanctions, seizure, and default. For newer generations of investors, we had entered a whole new world. For those with more tenure, we had returned to one that we thought was gone for good.

How the Markets Fared

With interest rates spiking and fears about the economy on the rise, the first quarter wasn’t a good one for bond investors. The bellwether 10-year Treasury yield jumped from 1.5% to start the year to over 2.3% at quarter’s close. And it didn’t stop there. As of the time of this writing, rates have soared past 3%, essentially doubling in the first four months of 2022. This led to losses in traditionally safe aggregate bond portfolios of nearly 6% for the first quarter. High Yield bonds didn’t do much better. In fact, in the credit-sensitive ends of the market, the higher-quality names did the worst, as the junkiest of junk bonds were bolstered by their higher coupon payments as rates rose. After hinting at and then finally forecasting the need to raise short-term interest rates at their January meeting, the Federal Reserve finally lifted the overnight discount rate a paltry quarter of a percent at their March meeting. Despite their clear admission to being wrong about the magnitude and duration of inflation, the Fed was still timid during the first quarter to raise rates and now is sprinting to catch up with a half percent increase at their recent May meeting and several more increases promised this year.

A final note about interest rates: Many have made a big deal about the yield curve inverting of late. An inverted yield curve typically means that Treasury bonds with longer maturity dates are yielding less than those of shorter maturities. In the past when this has happened, it has been a harbinger of a looming recession. Although there were a few instances where that phenomenon happened in 2022, those instances were not of the nature and magnitude that would indicate a recession is on the way. For the yield curve to be inverted in a concerning sense, very short-term rates (less than one year maturity) would need to be yielding more than longer-term rates (10 or 30 years). That is not remotely the case presently with the spread between the 10-year and one-year treasury still positive by over three-quarters of a percent. We discuss the specter of recession later in our commentary, but at this time, it has very little to do with the yield curve.

With inflation wreaking havoc on corporate costs and household expenditures alike, and Russia’s invasion of Ukraine adding both to investor fears as well as further disrupting supply chains and added energy and commodity costs, stocks were under pressure during Q1. Growth stocks (especially of highly valued tech companies) sold off across the board in both the U.S. and abroad. Many theorized that this was due to the idea that higher interest rates made the future prospect of growth companies less attractive in present-day terms. We believe it was something far simpler. As we have previously commented on, growth stocks came into 2022 with far higher than normal valuations. As investors looked to reduce risk as the future’s prospects started to dim, they took more money off the table in these high-flying names than from more reasonably valued cyclical stocks. Generally, value indices were only slightly changed during the quarter, but most of that was due to strong performing energy and other commodity-related stocks.

Commodities soared during the quarter, bolstered by both rising oil prices due to the Ukraine conflict as well as inflation-related surges. Emerging markets stocks weathered the rising interest rate storm well in the first half of the quarter, led by big gains in committee-dominated Latin American countries. However, emerging markets stocks in Asia came under pressure after the Ukrainian invasion took center stage. Further, despite COVID cases and deaths receding by the end of the quarter after spiking to start the year in the U.S. and much of Europe, China’s continued draconian zero-COVID lockdown policies also led to pressure in Chinese and broader Asian stock markets.

As such, the typical global balanced portfolio (a blend of domestic and international stocks – large and small, a balance of growth and value, mixed with historically safe harbor investments in high-quality fixed income, sprinkled with some natural resource exposure) saw broad price declines leading to losses of 5%-10% in Q1.

Steady as She Grows

Imagine what it’s like to pilot the current business environment for companies large and small. Demand for goods and services is through the roof. Yet orders are difficult to fill. Supply chains have been disrupted for over a year. Shipping is backed up and incredibly expensive due to spiking energy costs, high demand, and logistic worker shortages. Your employees are either leaving and moving to new cities or careers or they are staying and demanding much higher wages and added benefits (both traditional and ‘quality of life’ related). Many companies want to grow to meet the added demand but are having difficulties replacing current employee vacancies, let alone filling newly needed positions. There are presently 11.5 million unfilled jobs in the United States. That’s over 50% higher than the pre-COVID record high.

Despite all these headwinds, the Institute of Supply Management™ Report on Business® (ROB®) still shows that American businesses are optimistic and are expecting to continue to grow. The recent April ROB for the manufacturing sector came in at 55.4%. Although that was down from 57.1% in March and over 60% in December, any reading above 50% suggests future expansion, so 55.4% is still pretty good. The ROB for the services portion of the economy, the Non-Manufacturing Index, decreased to 57.1% from 58.3% in March, down from over 62% in December, again indicating strong expansion. Are these survey results suggesting a roaring economy in the year(s) ahead as they did throughout much of 2021? No. But American companies are generally still bullish and are striving to continue to grow… despite an onslaught of challenges. Net-net, current conditions still suggest a broad-based economic expansion in the coming 6-12 months, albeit at a more measured pace.

We Decline the Decline… in GDP

The initial print for First Quarter Gross Domestic Product (GDP) suggests that the economy shrunk in the first three months of 2022 by 1.4%. But did it really? Maybe statistically in real terms (i.e. adjusted for inflation), but did it shrink from a pragmatic perspective? Is our economy truly stalling out, or worse yet, shrinking? Absolutely not! It is important to understand the context of Real GDP statistics. Real GDP is current GDP in present-day dollar terms reduced for the impact of inflation (specifically the measure of the Price Deflator). In normal economies, even during times of many recessions, inflation runs between 1%-2.5%. So, if the economy shrinks in present-day dollar terms quarter-over-quarter, or even just stalls out, in real terms it declines. If that happens two or more quarters in a row, this is the essence of a true ‘recession.’ But these aren’t normal times. GDP in present-day dollar terms increased in Q1 at an annual rate of 6.5% to $24.38 trillion, a jump of nearly $380 billion! That is robust growth. Wages are growing. Sales are growing. Earnings are growing. And they are all growing fast. Whether we’re entering into a technical recession, due to two or more quarters of shrinking Real GDP, or not, our economy is not shrinking – in fact, quite the opposite.

Economic growth or contraction almost always is linked to the jobs market. Recessions mean layoffs and booms mean hiring. Where is the labor market right now? Red hot. April’s unemployment rate was unchanged from March’s at 3.6%. The U6 unemployment rate, which adds those that are ‘underemployed’ (e.g. working part-time when they’d like to be working full time) to the 3.6% fully unemployed number, was 7.0%, versus 6.9% in March. These are incredibly tight labor markets – the tightest in several generations. Unlike the technology-led labor boom leading up to 2000 and the real estate boom prior to 2007’s peak, demand for labor in this market is broadly diverse and has pent up demand backing it up, with as we previously stated, 11.5 million unfilled open jobs in the U.S. today. With this much negotiating power, workers have leverage, and they are using it. Over the last 12 months, average hourly earnings have risen 5.5%. Is that keeping up with inflation? No. But it certainly is softening the blow. However, if you have already retired from the workforce, like 69.8 million Americans receiving Social Security benefits at the end of 2021, wage growth doesn’t help.

To RE, or not to RE, that is the question.

With inflation on the war path, whether you are still working or not is only one factor on how hard of a hit American households are taking. Whether or not you own your home or rent is the other great dividing factor. The Washington Post reported that according to a recent study from real estate research firm CoStar Group, nationally, rents rose a record 11.3 percent last year. And that’s just the average. The major markets of Tampa, Las Vegas, and Phoenix have spiked nearly 30% since the start of the pandemic. No amount of wage growth is likely to offset that!

If one was fortunate enough to own their home (or other real estate), however, then the story was quite the opposite. The National Association of Realtors (NAR) reported that median existing-home sales price for March was up 15% from the same time last year. This increase was confirmed by the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index which showed “all nine U.S. census divisions, report[ing] a 19.8% annual gain in February.” Despite sales slowing moderately due to these higher prices and more expensive mortgages (due to rising interest rates), the NAR reports that supply remains extraordinarily low at just 2.0 months. Six months of supply is more typical of equilibrium in the housing market. What remains to be seen is if the market will adjust to higher mortgage rates and resume demand, or if affordability will knock some out of the market, or perhaps just down to a lower-priced home than originally desired. If the sale of new homes is any indication, then things may be cooling off over the next few months. The U.S. Department of Housing and Urban Development recently reported that new home sales had slowed 12.6% year-over-year. And that the 407,000 new houses for sale at the end of March represented a supply of 6.4 months at the current sales rate (more in line with equilibrium). Will this slack in new home sales, which is usually targeted to newer developing communities, spill over into the far larger and more widely impactful existing home sales market? Time will tell.

Consumers Are Charging Ahead

As we often discuss, consumers’ moods are usually driven by two primary and one secondary factor. If the job market is strong and home prices are on the rise, most Americans tend to be optimistic. Occasionally, a big up- or downswing in the stock market can lean on sentiment. Lately, however, another element has overshadowed these traditionally weighty factors. Multi-generational highs in inflation have taken center stage in the mindsets of consumers. When American households can even find the goods that they want to purchase, they are met with astronomical price increases. Though retail sales have been growing, up 6.9% last month, those increases are mostly due to price increases in food, energy, and other costs of goods; and not due to increased volume of items and services purchased.

The Conference Board’s report on Consumer Confidence held steady at 107.3 in April verses an upwardly revised 107.6 in March. These numbers compare similarly to the optimistic consumer data we saw before the great financial crisis in 2007. That’s quite an accomplishment given the fears of inflation, scarcity of goods, and the x-factor of the highly promoted Russian invasion of Ukraine. What deserves note is that consumers seemed to pile on debt last month at record levels (over $50 billion).

This jump is curious. With inflation on the rise and the Fed raising rates, did consumers go on a shopping spree for bigger ticket items while interest rates were still reasonable? Or is there a subgroup of Americans that can’t make ends meet due to higher prices, and thus are being forced to extend themselves on credit just to get by? We will likely learn more as the trend develops or reverses in the coming months. Either way, the average household in the U.S. was in good shape to absorb this increased borrowing. Though off their lows, the amount that families are spending to service their debt remains near multi-generational lows, nearly a third less than the exuberant and, most would say, irresponsible spending at the end of the housing boom 15 years ago.

PIERing Ahead…

I’ve been speaking about the likelihood of the current phenomenon regularly since the summer of 2020 when policymakers began throwing around trillions of stimulus dollars as easily as a child tosses a penny into a wishing well. And maybe that’s the appropriate analogy, except our leaders in Washington and at the Fed weren’t wishing for a shiny new bike, they were hoping to solve one economic calamity without causing another one. The economy is a delicately balanced equation of hundreds of inputs, each one having a ripple effect on the others. An example, the Fed cuts interest rates, and buying a house becomes more affordable, driving up purchase volume and prices, creating supply shortages, further inflating values, driving up rents, creating affordability issues for younger workers, who move to lower-cost cities, which further drive-up housing costs in those cities, which displaces lower and fixed-income residents in those cities, which leads to rent control laws, which reduce investment and upkeep, etc., etc., etc. of items and services purchased.

In normal environments, pitching an economic penny into a well makes a bunch of smaller ripples. But when policymakers throw over $10 trillion in record-breaking inputs into that economic equation, those ripples can turn into tsunamis. When the calm waters of inflation were generally less than 2.5% for over two generations, sustained 8%+ inflation looks and feels exactly like that. This wave of higher costs leaves those at the marginal ends of society scrambling to keep their heads above the crashing waters.

And that’s just one wave, hitting one economic shore. Add in the giant Mavericks we are facing such as supply chain disruptions that have cleared out store shelves and stock rooms; or a labor shortage hamstringing virtually every industry in America, especially hospitality which was just coming back from the brink after COVID shutdowns. What you get could rival a doomsday, Hollywood comet-impact film. Fed Chairman Powell has recently said that they are attempting to engineer a “soft landing.” These are the same economic-climate-deniers that less than a year ago were telling us not to worry, that inflation was just “transitory.” With stakeholders as diverse as corporations and Wall Street investors relying on steadily growing earnings, to young workers trying to buy their first home, as well as fixed-income seniors clipping coupons to fill their grocery carts, there is simply no way that everyone will be able to successfully surf all these waves. Some are going to get tossed in the whitewater. The ultimate questions will be who and how bad, and will they be able to resurface relatively unharmed when the waves pass? Our PIERrspective of the scenario is that the first set of waves we’ve seen have many more looming behind them, potentially even bigger. Surfing each as it comes is the only thing one can do. To stand on the shore idly looking at the wall of water coming towards us is simply not a tenable option.

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