After a great ten-year run in the financial markets, the first six months of 2022 has been the worst start to a year since 1932. In fact, if the year were to end now, 2022 would be the 7th worst performing year on record. Since our last market commentary, a chorus of leading economists, business leaders, and investment firms, including Former Treasury Secretary Larry Summers, economists Robert Shiller, Elon Musk, and JP Morgan Chase CEO Jamie Dimon, have recently predicted a recession. Meanwhile, the Federal Reserve Bank of New York reported that the economy is very likely on a path to shrink 0.6% this year and 0.5% next year. This is in contrast to the New York Federal Reserve model earlier this year which predicted growth, while in early July Atlanta Federal Reserve GDPNow gauge was released which predicted the second quarter running at a negative -1%. The official numbers will be released on July 28th but if this is true, it means the economy is already in a recession. In this commentary, we will comment on the current run of inflation which we believe is what is driving the financial markets lower, how long financial market downturns typically last, and the historical indicators signaling the worst of the sell-off might be over.
Inflation is one of the most destructive forces known to economics. Inflation erodes the purchasing power of your dollars, lowers the standard of living, and is especially worrisome for lower income earners. As prices rise, workers demand more money to compensate for the increase in the cost of living. If inflation becomes entrenched, it develops into a negative feedback loop that feeds on itself.
A combination of factors has led us to this point where inflation risks are becoming more entrenched. High valuations coming into this year, over inflationary monetary and fiscal
policies, global issues like COVID-19, China’s zero tolerance policy of COVID-19 which has
created global supply chain problems, and the conflict between Russia and Ukraine which has driven up food and fuel prices, have all lead to the highest inflation in over forty years.
During the pandemic, the Federal Reserve (Fed) committed even more stimulus than
during the financial crises to keep the economy from falling into a deep recession. The byproduct of taking interest rates to 0%, and then expanding their balance sheet to $9 trillion dollars, the Fed also helped to inflate asset prices: stocks, bonds, and real estate. As investors saw the value of their portfolios and homes grow, they began to spend more. At the same time, massive fiscal stimulus loaded consumers with cash. Turns out, many of the consumers who received cash, did not need it, so they spent their stimulus money. With fewer people working due to COVID-19, and with both high end and lower earning consumers ordering more goods and services, companies were unable to keep up with demand, so they began to raise their prices. The Federal Reserve thought these price increases would be transitory, ending once the fiscal stimulus ended. On the contrary, inflation has continued to rise because the Federal Reserve did not expect COVID-19 to linger, China’s continued COVID-19 lockdown, and the war in Ukraine and Russia which has exacerbated already stretched global supply lines. With demand still strong due to very low unemployment, and consumers entering this year with record levels of cash in the bank, companies continue to raise prices.
Food and energy could turn out to be the hardest commodities to get under control.
Currently, food and fuel inflation are being complicated by the conflict between Russia and
Ukraine. Russia is one of the world’s largest oil producers, and Ukraine produces about 13% of the world’s calories. Both countries major commodity exports have been reduced due to the fighting. Moreover, natural gas, which has spiked in price in part due to the war is also a key component in fertilizer; this has caused fertilizer prices to surge, and in turn has caused farmers to use less fertilizer this year. Over time, this will reduce food output, causing further price hikes in food.
Oil is also a problem. Although the Baker Hughes oil drilling rig count is increasing, the
increased drilling is being done by small players. The rig count is currently at 750 rigs operating in the USA, which is up almost 300 rigs from last year, but it is still down -333 rigs from its recent high at the end of 2019 (Baker Hughes). American Oil production is also down a million barrels a day since that time period (EIA- Energy Information Administration). Historically, when oil prices rise, the major oil companies aggressively pump and explore new fields to take advantage of the high oil prices.
Today, autos account for roughly 60% of the demand for oil, but with the rise of electric vehicles, the major oil companies see a day where oil consumption is going to decline. In an interview on June 24th, CEO Darren Woods of the oil giant Exxon is predicting that by 2040, every new passenger car sold in the world will be electric. In 2021, 9% of all passenger car sales were electric vehicles, including plug-in hybrids, according to market research company Canalys. That number is up 109% from 2020. Increasingly the large oil companies are uncertain that the large amounts of capital and time needed to explore and develop a new field will pay off. They are also uncertain that they would even get the permits and pipelines necessary to connect those fields to existing infrastructure. While speaking in Singapore on July 1st, the CEO of Shell essentially mimicked these same thoughts and pointed to a decline of almost $1 trillion of investment in the fossil-fuel industry over the last three years which would not have happened under “normal circumstances.” Thus, they seem content to sit on their existing assets and milk them for the highest prices possible as they convert their existing business to a decarbonized future.
Fortunately, some of these problems underlying the current run of inflation are
improving or at least starting to bottom out. For example, economists have documented a wealth effect that investors tend to spend more when the equity market rises. This tends to add upward pressure on prices, especially high-ticket items like real estate. Last year, historical valuations were all at the high end of their traditional ranges. However, the current financial market correction has brought valuations back down, and a reduced wealth effect is starting to take place as investors spend less as their gains evaporate.
Currently, the S&P 500 is trading at 15.4 times its next 12 months of expected earnings
according to FactSet, just a hair below its 15-year average of 15.7, and should start to offer some support to falling prices. Furthermore, consumer sentiment, a gauge of future demand, has plummeted. As demand drops, inflation should fall. The University of Michigan Consumer Sentiment Index, whose preliminary estimate for June plunged to a record low of 50.2, down from 58.4 in May, and worse than even the Financial Crisis. Consumer sentiment was 85.50 one year ago. This is a change of -14.04% from last month and down -41.29% from one year ago. This large drop implies that consumers will be spending less in the near future which will in turn reduce demand, and unfortunately hurt economic growth, but it will help subdue inflationary pressures which the market is most concerned about.
In regards to supply lines, we believe that with increased vaccinations and time, COVID-19 will eventually run its course and supply lines will eventually come back on line.
Furthermore, the Federal Reserve is aggressively fighting inflation by hiking interest rates at the fastest pace in over 30 years. The Fed’s game plan to deal with inflation is to slow the economy down in order to reduce demand and let supply catch up. We believe this is already happening as retailer’s inventories of unsold items are beginning to build:
We also agree with Larry Summers that bringing this inflation down is going to be
painful. Anyone looking to buy a new home or car already knows this. Summers, who served
under both presidents Obama and Clinton, told Bloomberg news that “when inflation is as high as it is right now and unemployment is as low as it is right now, it’s almost always followed by a recession within two years.”
In terms of what this means for financial markets, according to Deutsche Bank, the last 15 recessions since 1960 the stock market pull back lasted 9.6 months, and the median market decline was -24% (See chart below).
Moreover, Guggenheim Research does further analysis to point out that if you just look at major market pullbacks that went down more than 20% (which we are currently in), the average sell-off lasted 11 months and the average decline went down -27% (see chart below).
The market low thus far was on June 17th and saw the S&P 500 down -23.2% and the
technology heavy NASDAQ was off -34.1% according to William O’Neil & Company. So this
current pullback is already near the averages in terms of decline, but still needs more time since this sell-off only started in December 2021.
Moreover, in a majority of the bear markets, the stock market hit bottom only around the time the Fed started loosening monetary policy again. The Fed’s current tightening is probably still in its middle stages. In June, the central bank raised interest rates by 75 basis points — the first time that’s happened since 1994. The Fed has signaled that it intends to raise rates several more times this year to rein in inflation. Thus, the first indicator we are looking at before the markets can resume on a sustainable upward course is a change in monetary policy. Next, we need to see a change in the unemployment rate. Although it sounds counter intuitive, a rise in the unemployment rate would indicate a drop in demand and thus less inflation. Less inflation would allow the Federal Reserve to stop raising interest rates which would cause stocks, bonds, and real estate to rise in value in the eyes of investors.
Besides the Fed getting inflation under control, the other variable we see that could cause the financial markets to reverse course would be a resolution to the fighting in Ukraine. A diplomatic resolution to the fighting that would bring Ukrainian food and Russian oil and commodities back to the world markets would lower inflationary pressures around the world.
We believe a resolution to the fighting is not as unlikely as it may seem. Both sides have suffered heavy casualties, both in human and economic terms. Militarily, the Russians appear to be running low on supplies, and the United Kingdom Ministry of Defense publically estimated that after the first 100 days of the war which occurred on June 3rd, that Russia had already lost a third of its invasion force through death, capture or wounded. Anecdotally, we now see Russia deploying 50-year-old tanks and using anti-ship missiles to attack land targets because they are running low on supplies as Twitter videos like to point out. Economically, the Russian Finance minister Alexei Kudrin said on April 27th that he expects the Russian economy to contract by 12.4% in 2022. The real Russian economic contraction is most likely far greater than this. If the fighting were to stop now, the Russians would control the Donbas, which they could claim as a victory because the Donbas region speaks Russian as its primary language and it is made up by a majority of ethnic Russian people. The Donbas is also important because it would provide a land bridge to connect to Crimea. Crimea is important because it is Russia’s most important warm water naval base that allows Russia to project naval power around the world, all year round. During the Russian takeover of Crimea in 2014, the Ukrainians cut off water supplies to Crimea.
A land bridge over the Donbas would allow Russia to resupply this geopolitically important area with cheaper and more secure water sources. Bloomberg reports that over the last five years Russia has spent 1.5 trillion rubles (roughly $20 billion) to supply water to Crimea. On the Ukrainian side, even though they show plenty of willingness to continue fighting they are
dependent upon American equipment. Without American equipment, the Ukrainians could not continue to hold back the Russians. If the Ukrainians accepted a settlement, the U.S. could pledge continued military and economic aid for Ukraine to defend and rebuild while the Europeans could offer European Union membership. The Biden administration would score an important political victory, lower inflation, and create a market rally right before the mid-term election.
In conclusion, we believe a resolution to the fighting in Ukraine could spark a large
market rally. However, we believe that even though valuations on financial assets have come
back to historical normal levels, a sustainable market uptrend will not occur until inflation comes under control and the Federal Reserve changes course on its current monetary policy. Moreover, the risk of a Fed over shoot is high and a recession seems increasingly likely. As a result, we believe that being more defensive (such as having more cash and short duration investment grade bonds) while investing in large capitalization, brand name companies who are returning cash back to investors as well as who provide goods and services that consumers need to use on a daily basis provide the best risk adjusted returns in current volatile environment.
We thank you for your continued support.
Sincerely,
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