What the hell is happening? May 2022
What the hell is happening? May 2022
The Fed's Wealth Effect, Inflation and the Bond Market Cracking.
This is the second post in the WTHIH series. The first one was sent last July.
In the first WTHIH (What the hell is happening?) we took four hypotheses that the market seemed to be adopting and tested them. Find below the results that we produced:
Hypothesis 1, inflation is back so buy quality mega-caps to protect your cash.
Result: Buying mega-cap blue chips at any valuation cannot protect your cash from loss.
Hypothesis 2, equities will be hurt from the Fed tapering and the increase in interest rates.
Result: Well run businesses cannot be hurt from a change in Fed Policy.
Hypothesis 3, protection from higher inflation can be achieved by buying treasuries at a 1% yield.
Result: Buying treasuries will not protect you from higher inflation going forward.
Hypothesis 4, investing in an index fund does not carry the risks that investing in individual stocks does.
Result: Investing in an index fund offers you diversification from a more concentrated portfolio, but does not shield you from the risks of the overall market.
So what happened?
(Philoinvestor hit the nail on the head) 👇
Mega caps are selling off with seemingly no end in sight.
Equities with more reasonable valuations are holding up.
Treasury yields have rallied (bonds sold off) with the 10-year yield at 2.8% as inflation has picked up materially since last July.
Indices are selling off. The S&P500 is down 20% from peak, Nasdaq down 30%.
Taking a transitory step back for CONTEXT
“Transitory inflation” first entered the lexicon in early 2021. Fed Chairman Powell used that term to describe the picking up in inflation as the economy reopened. The Fed believed that inflation was transitory and there was no need for rate hikes.
For context, this spike in inflation was caused by an unprecedented confluence of factors.
Energy costs were creeping up since the March 2020 bottom.
US budget deficit spiked to ~$3 trillion for 2020 and 2021. At least 3X higher than previous years (!)
Covid measures and lockdowns caused port congestions resulting in a spike in freight rates. Spike in demand also pushed rates up.
Wage costs moved up fast.
Companies started pushing these increased costs to their customers.
This had a domino-like effect on prices.
Wealth effect from the post-Covid bull market pushed up demand; causing further inflationary pressures.
Why the “transitory inflation” story?
The Fed was deep in accommodative mode to support the economy after the Covid wrecking ball. They believed that the economic recovery was still fragile as vaccinations were slowing and future Covid variants could endanger the recovery.
If they pivoted; things could turn south and they didn’t want to take that risk. So they remained steadily dovish - this was in April 2021. Unfortunately for J-Pow and the Fed, things unfolded differently. The chart above shows how inflation moved steadily upward ultimately forcing the Fed to reverse course.
The Fed’s fear was that inflation expectations would get out of hand, causing a negative spiral in the economy and the financial system.
The Fed Pivots 😱
The market didn’t care if the Fed was right or wrong in its “transitory inflation” call, and it didn’t really matter. Bond yields were creeping up and the Fed couldn’t let them spiral.
The Fed became more and more hawkish, revealing to the world that their primary aim was to bring down inflation, no matter the cost…
What cost? Equities!
Drastic times call for drastic measures. The Fed aims to bring down inflation even if it brings down the economy with it. It doesn’t matter if monetary policy can’t influence supply-chain disruptions or the price of energy via geopolitical events.
The Fed’s mandate is for maximum employment and price stability - and they aren’t ready to fail on the latter.
We have been in a two month sell off where seemingly nothing is safe, and Fed officials are piling on the hawkish messages on top.
Market participants are currently hypersensitive and comments like this increase selling pressure even further. Remember the old adage “Don’t fight the fed” ?
The Fed is using the wealth effect to tame inflation. The Fed’s hawkish signalling is keeping a lid on treasury yields but sacrificing stock market valuations in the process. Powell has signalled that the Fed will continue until they see inflation come down.
…the central bank needs to see “inflation coming down in a clear and convincing way” and closer to the 2% target previously established.
What’s the gist?
Sentiment will remain uncertain until inflation worries fade. When signs that inflation is coming down appear, calls for the Fed to pivot once again will pile on.
When that happens, we should see a strong response from stocks in the form of a rally. But life is never that linear. More on this here.
Always know what you own, and know it well. The spike in volatility is bound to shake out the weak hands causing them to dump their shares at lower and lower valuations.
Remember the second hypothesis from the previous WTHIH article? The result was that well run businesses cannot be hurt from a change in Fed policy. But price matters.
Why sell something at rock-bottom valuations just because the Fed is trying to control inflation by hurting the stock market? They are at rock bottom for a reason.
And that’s because they have already priced in this future expectation. I am not saying that the stock market is at rock bottom valuations (far from it), but you better believe some stocks are.
How did we get here? Keynesianism 🤦🏻♂️
In March I wrote a thread on Keynesian economics and how profoundly they have influenced our world.
Keynesian policies (i.e. deficit spending and low interest rates) as a means to support economies and fight recession brought us where we are today. Where is that? 👇
If debt was at more sustainable levels, a spike in treasury yields would not be such a destructive scenario. But with the massive amount of government debt and super low funding costs makes the U.S. fragile to small changes in economic variables.
And this is exactly why the Fed is reacting like this. They are trying to prevent the bond market from cracking. This is why their signalling will remain vigilant until inflation abates. Expect volatility, both ways.
Now is the time.
For the long-term investor looking for bargains, now is the time.
“The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”
-Warren Buffet
Further Reading
Why you want stocks to go down.