Risk Assets Fall As Inflation Fails To Resolve Quickly!

By Mitchell Anthony

September 16, 2022

2022 has been a volatile year for financial assets. Stocks, bonds, and real estate have all slid in price considerably as inflation has remained high contray to the forecast of the Federal Reserve last year. Inflation is the primary driver of liquidity that flows into risk assets.  During periods of low inflation and accommodative monetary policy liquidity drives risk assets higher. However when inflation becomes unfriendly that causes the Fed to move to remove liquidity from the system and risk assets perform poorly.  This is what we are experiencing today.

The consumer price index or CPI rose to 9.1% this year and is still holding at 8.3% or more currently. Month over month data looks a bit better with only a modest increase in inflation over the last three months but overall the data is still awful.    As a result interest rates have risen this year and have been volatile with treasury yields now close to 3.8% and mortgage rates over 6%.   Almost all risk assets have seen volatility as optimism and pessimism has played out. The fear is about a terrible economic bust that seems unlikely but can’t be discounted entirely until inflation has been subdued.

Expected Economic Slowdown has not yet arrived to subdue Awful Inflation

Financial markets rallied in July as the economy recorded a second consecutive quarter of negative GDP and at the same time most economists were forecasting more problems ahead for growth. An economic slowdown is the medicine that investors feel is needed to subdue inflation and as a result risk assets rallied substantially in July and August on this hope recovering almost half of the losses that were incurred in the first six months of the year.  However recent news on the economy shows the slowdown is not materializing and in fact economic conditions remain robust particularly when reviewing trends in employment and the demand for shelter.

Treasuries and corporate bonds fell over 25% in the first half of the year and had a small bounce in July and August but have now fallen to a new low for the year of close to 30%. Stocks fell over 20% in the first half of the year and then recovered more than half of the loss by mid August but now most of that recovery is slipping away.  Real estate investment trusts likewise fell over 20% in the first half of the year and then had a strong bounce only to see it ebb away as well.

 Consumer spending has been very strong

The US economy has been resilient and the expected slowdown has just not materialized as expected.  Consumers continue to spend almost recklessly despite low levels of consumer sentiment and confidence which are clearly out of sync with what consumers are actually doing.  Retail sales data continues to make new highs despite high inflation.  Admittedly there has been only modest growth in retail sales when inflation adjusted. The drivers of high level of consumer spending seem to be tied to strong employment and good wage growth.  On top of that consumers have cash, wealth, and access to credit that keeps their checkbooks open. There are lots of reasons to expect consumer to stop spending. This would include higher costs of credit, rising prices for goods and services, and eroding wealth. Further stock prices are down, bonds are down, crypto has fallen more than 70%, and real estate has hit a plateau.

Corporate spending remains high

Corporate spending on productivity equipment remains high with only a few cracks visible. Consumption themes on cloud computing equipment and digitization of data remain intact and continue to drive spending on this technology which has been the backbone of this economy for many years.

Too much liquidity in the Economy causing reckless spending by consumers

M1 which is the measure of the liquidity that is in the economy had a record rise in 2020 from 5 trillion to over 20 trillion.  This was mostly because of Washington policy that put far too much stimulus on the Covid problem than was needed.  As a result there is just way too much cash in our economy and it is driving strong consumption and inflation in prices. The Fed has been working hard to mop up this excess liquidity but he has yet to make a significant dent in the problem.

The Outlook.

We believe markets will remain volatile until inflation rolls over! The inflation will undoubtedly end and it is just a matter of time! Currently most think the time frame will be short? As a result investors are reluctant to leave risk assets in a significant manner because of this belief. Investors do fret about how much damage will be done to the economy as we rein in inflation and that’s what produces the cycles of pessimism. However investors are clearly optimistic that the economy will get through this cycle without major damage and as a result markets will be quick to rally on good data points.  Obviously the data points to follow are tied to inflation. Both the CPI and the PCE must be followed carefully. Once core CPI is below 6% and on a trend to 3% the markets will likely be at new highs. However this may take more than a year.  The market lows seen in June will likely hold as inflation data seems set to decline. However wages and shelter costs are the strength in the data and will likely remain strong in the short term and cause investors to fret.  New lows are possible if the inflation remains very sticky.  We have a 25% cash position that we plan to put back in equities as the outlook improves.

We remain optimistic that the markets will see new highs within the next few years and maybe much sooner.