Building on our last Commentary update from last spring (see below), the markets are back to experiencing some extreme volatility. The difference from then to now is that the Federal Reserve has finally recognized that the inflation they earlier saw as “transitory” is actually here for a while, and action is needed to control it. The Fed’s mandate is for stable prices and full employment. Calls to broaden their areas of responsibility are unwise, but that’s a discussion for another time. For now, the markets are adjusting to the affects of impending Fed tightening. This is necessary, albeit painful, and many growth stocks will be affected the most as their prices are heavily influenced by future earnings, which inflation dilutes. This period of adjustment may go on for some while longer, and we have not yet seen sentiment reach the extreme fear levels notable at market bottoms. But those levels of fear tend to come with little notice, and the resulting bottom establishes itself unpredictably. So, as hard as it may seem, patience is warranted as this plays out. If we were looking at an impending recession, that would be different, but at this point we are not.
The labor markets are holding firm, and the unemployment rate is low. Supply chain imbalances are starting to work free, and that will aid in slightly bringing down inflation. Corporate earnings are holding up, but guidance is mixed. The pandemic has transitioned to an endemic and the Omicron variant, which is more contagious is also less lethal, so we’re collectively starting to just live with Covid. This is good for getting back to normal. Also on the plus side, we are still operating under the 2017 tax structure, and it appears the proposed spending and tax legislation has stalled completely, avoiding damaging inflationary spending and growth-inhibiting taxation. This should hold back recession concerns. This leaves the main driver the inflation and interest rate question. What was previously expected to be three quarter-point increases during this year, is now being priced at four or five. We won’t know what initial actions the Fed will actually take until they conclude their next open market meeting.
Since we know interest rates and bond values move inverse to each other, we have started paring back fixed-income exposure and expect to hold more cash for the duration of the upcoming interest rate cycle. Stock prices are also reacting negatively, but for the immediate period, we want to see how fear gauges play out and are looking for a short-term bottom. These initial reactions tend to lead to overselling, which corrects itself. Many indexes have already slipped into correction territory and some asset classes are in bear markets. But in the absence of damaging policy changes, this may not last much longer. We are monitoring events closely.