The last few months have experienced negative market action tied to several factors, some of which have abated, but some of which have lingered. The pressing economic issue of these times is inflation, and along with that the necessary adjustments to interest rates required to combat it. After over a year of denial, the Federal Reserve has come to acknowledge current inflation trends are not merely “transitory”, but structural. There are three fundamental reasons for the recent run-up of inflation. And it is because three factors all came into play at the exact same time that inflation so rapidly went from subdued to the worst in four decades. One of them is supply chain restrictions resulting from lingering Covid imbalances in labor and materials, hindering manufacturing. This is the least significant of the three, but still impactful. The other two go hand-in-hand and have the greatest impact, and those are too much fiscal and monetary stimulus. The monetary side of this ledger has been the policy of holding emergency-level quantitative easing and interest rates for too long. In other words, interest rates have been too low for too long, and Federal Reserve purchasing of Treasury debt and mortgage debt has been excessive, exploding their balance sheet to nearly $9 trillion. Finally, these imbalances are being corrected, with the Fed scaling back and soon completely halting its quantitative easing, and scheduling interest rate increases starting this month. Just a couple weeks ago, the futures markets were pricing in a half-point increase at the March meeting being more likely than a quarter-point increase. That has now flipped with the Russians invading Ukraine. More on this below.
On the fiscal side, over the last couple years, in response to the pandemic, the federal government flooded the economy with trillions of dollars of additional spending, often without regard for where it was going, who was getting it, or if it was even necessary. While we had certain reservations as to the magnitude and nature of some of these efforts at the time, no one knew how the pandemic would play out, so fair enough regarding those early efforts. We won’t Monday-morning quarterback those early decisions. But along the way, even with indicators questioning the need for continuation, and in many cases those programs being counterproductive, they have kept pumping the economy with more money than it could absorb. We wrote about this at the time in our newsletters, so we won’t relitigate that here. This is the fiscal over-stimulus part of inflation. When any economy of a given size is fueled by cheap borrowing costs and more cash than it can absorb, prices are bid up on the things people want, because buyers have more money to spend and supplies are limited. This is Econ 101. Supply and demand. This brings us to the one concern that has largely abated which is of the legislative risk nature. The previous proposed Build Back Better plan would have resulted in trillions of dollars of additional spending and regulation, coupled with a multi-trillion-dollar tax increase component. This would have exacerbated the problem by adding even more dollars chasing still-limited goods and services, jacking up inflation further. And, the added burden of higher taxes would have resulted in a certain recession. However, with this legislation likely permanently sidelined, that risk is severely reduced. That alone calmed the markets earlier this year for a while.
This led to the market re-focusing on the inflation/interest rate issue, along with positive corporate earnings resulting from a healthy economy and labor market. Just yesterday the Labor Department reported unemployment at 3.8% and new jobless claims for last week coming in at a low 215,000. The underlying economy, working off the 2017 tax rates and no damaging policy disruptions, is emerging from the pandemic nicely. The result of all this was the market working on a technical bottom to the correction we are in. Until a week and a half ago. The Russian invasion of Ukraine is now adding an additional element of uncertainty to the equation and specifically the energy sector of the economy. Now, the futures markets are pricing in an almost-100% chance of only a quarter-point rate increase this month, which was largely confirmed a couple of days ago by Chairman Powell’s comments. The markets had a nice positive reversal a week ago as it appeared the Russian army has had more trouble than anticipated in conquering the scrappy and brave Ukrainians. That reversal has led to a new rally attempt, which any day now could lead to a follow-through day, marking a new uptrend. But, with the attack on the Ukrainian nuclear power plant yesterday and evidence that Putin’s frustrations may lead to him taking more desperate measures, uncertainty continues to rule.
At this point, we will continue to study the technical action and focus on long-term fundamentals. Patience is warranted. We’ve made some incremental portfolio adjustments and will do more as necessary if warranted.