August 27, 2022
The big gathering of federal reserve types at Jackson Hole took place at the end of the week, and the most important speech was delivered by Jerome Powell, Chairman of the Federal Reserve.
For months this space has reiterated that the world has to stop throwing good money after bad. Put another way, the economy is not getting enough benefit from the money that is being spent, it was simply causing a rise in asset prices. For months, the world has been doubting that would happen.
Deciding how to proceed was a tough choice. Either take to heart a few statements and hints from the leaders of central banks around the world, or go with 30 years of history. History says they will cave and throw money at the problem. Yesterday, Powell said “we must keep at it [fighting inflation] until the job is done.’
Like all reviews, this is just one highlight, but the essence is that interest rates are going up, the central bank expects jobs to be lost, the economy to weaken and “a sustained period of below-trend growth . . . [that will] . . . bring some pain to households and businesses”. You can read his entire speech here: Monetary Policy and Price Stability.
The market is full of hopeful participants. Policy makers, analysts, media personalities and of course individuals who wish for things to continue the way they have been. The last thirty years have provided ample financial liquidity to ‘juice’ the system and force prices up for just about everything, with limited risk. This inherently favors the wealthy, those with assets and access. But that may be changing.
Again, here is a chart of the money supply (in green) and the stock market (in pink) over the past 40 years, since Reagan reduced taxes and interest rates started declining. It has been largely a one way run, and anytime the stock market dips, money supply was increased.
What does this mean to investors? The key messages remain intact. There will be a lot of volatility in the short term at least, perhaps in the long term as well. Investors should expect the broad path of that volatility to be down and if you are not a trader, standing aside is probably the best course of action.
Of course ‘dead money’ or cash is not always the best solution, so at some point it will be important to find places to put money. Currently short term bonds are getting all the attention, but soon the ‘strong’ companies, particularly those that pricing power and those that pay a dividend will attract attention and sustain their value.
For typical consumers, rising rates will mean higher payments. Shortages of items like energy and food will push up consumer prices (and inflation). Rising rates will also reduce consumption, particularly of items that require financing such as homes and cars.
These things do not bode well for corporate profits. Corporate profits have continued to grow as money flooded the system. Now increased rates, the expectation for a “sustained period of below trend growth” and inflation will impact profitability and few companies have recent experience in managing any of those factors.
In 2020, as COVID-19 began its course through the world, markets were exceptionally high after a 12 year bull market. At that time, the S&P 500 was at 3,300. It would be a reasonable expectation that the market works its way down to that ‘exceptionally high’ level in the coming months. That is about 22% below where the market is today.
Timing can make a big difference in portfolio returns. There are now at least four significant factors working against higher markets. These include:
- Central banks are trying to reign in inflation, which at its very core means stopping the rise in prices. Assets have been rising rapidly for far too long, and now the worlds most important central banks are all saying they will raise rates until inflation is under control. That is bad for rising asset prices, and stocks can be lumped into that group.
- Environmental concerns should not be underestimated. With weather causing havoc with water, storms and transportation all over the world, there are challenges to the normal flow of business. The modern world has very little experience with the changes, or managing the volatility. These concerns are likely to have a significant impact on trade and profits and perhaps even geopolitical issues.
- Consumer spending has remained robust as money supply was increased. As interest rates rise, discretionary spending is likely to slow markedly. The last time this occurred (PCE dropped by about 4% from peak to trough), in 2007-2009, stock markets dropped by 60% or more.
- Historical precedent suggests that the September/October time frame is very volatile in markets. A number of the most significant market declines have occurred as people return from summer vacation and begin their year end review. Of course markets move based on far more than just what month or day it is, the preceding items suggest that there may be some volatility ahead.
While cash isn’t working for you, having cash removes most risks from your portfolio until it is clear how markets will react to the changes that are sure to come. There are certainly places to invest that make great sense in the long term, so selling everything isn’t appropriate. At the same time there will likely be a better time to invest any spare cash.