The Situation is Inflation
Investment markets have continued their slog this year, and barring events entirely unexpected, both the stock and bond markets will post a down year in 2022. The story remains much the same, with inflation dominating the financial headlines, paired with a hawkish Fed rapidly hiking interest rates to curtail it. Investors have sold risk assets, leading to lower asset values, despite generally firm economic conditions at present.
To understand where we are, we need to understand where we’ve been. The sharp uptick in inflation that began last year was certainly received as an unwelcome surprise to a generation of investors accustomed to something else.
Enter the pandemic, and a global economy gripped by uncertainty and fear. Following government-imposed lockdowns, consumer demand in a host of economic sectors cratered, and in short order so did supply. The interconnectedness of global commerce was soon laid bare, too. As perhaps the most visible impact, new cars couldn’t be had for want of inexpensive semiconductor chips from factories in Asia. Recall too, amidst the chaos, it was only a year ago that retailers and consumers alike worried about the availability of merchandise for the holiday season.
This choppy pattern of uncertain supply reinforced itself for well over a year, into mid-2021. Although the lockdowns eased and authorities re-opened the economy, we had planted inflation’s seeds and they were about to grow very fast. By this time, we had thoroughly goosed consumer demand with three sets of stimulus payments over 2020-21 that sent over $800 billion to households. The government was spending mightily elsewhere in the economy, too, with PPP loans and other direct aid to states and localities.
As the economy reopened, consumer demand exploded, exacerbating supply-driven shortages. Demand for new cars when none were available drove used car prices to non-sensical levels. Airline fares and hotel pricing surged, as did gasoline and diesel—despite fairly abundant supply, the chokepoint was refineries, which had curtailed capacity when demand crashed. Food costs increased sharply on higher input costs.
The Federal Reserve, the same one now trying to put inflation back into the genie bottle, pumped truly historic levels of zero-cost money into the economy. The Fed lowered its overnight lending rate to zero at the onset of the pandemic in March, 2020, and held that rate for two years. Over that same time frame, the Fed was purchasing government and mortgage-backed debt, providing further stimulus to the financial system when it was already overheating. Easy and ample money found its way to financial assets, and also to real estate, bidding up prices to elevated levels.
Having grossly oversupplied easy money to the economy, the Fed has committed itself to reducing the inflation it helped to make. It has raised rates (from effectively zero) to 2.5% so far since March, and a further hike later this month is a certainty. At present, the market expects the Fed to pause hikes somewhere north of 4.25%, implying at least another 1.75% of rate hikes. The Fed will also begin the lengthy process of unwinding its prior asset purchases, which should have the effect of tightening economic conditions further.
The View Ahead
As we noted, both stock and bond prices have turned lower this year, and investor gloom is palpable. We expect the inflation numbers to improve, but probably at a pace slower than anyone would like, and the Fed has committed itself to restrictive monetary policy until shown it should do otherwise. Given that rate increases affect the economy on a lagged basis, a concern shared by many investors, ourselves included, is that the Fed will be tightening money past the point it needs to, inducing harm to the economy after inflation breaks.
We continue to be more constructive than the prevailing consensus on the outlook for the economy, and also for corporate profits. As to the former, the jobs market remains strong, and there are a record-high number of job openings available for prospective workers. While the recent inflation has crimped the lower end, the more affluent consumer continues to spend. On the earnings front, investors feared a slowdown in second-quarter profits, which did not materialize, and third-quarter expectations are for continued year-over-year growth. Per Factset, the S&P 500’s forward 12-month P/E multiple is 16.8, which is below its five- and ten-year average.
Two notable interest rate-sensitive parts of the economy are autos and housing, and both have become more costly to finance with the Fed’s rate moves. We are relatively more optimistic on autos, as that market likely has significant deferred demand. Keep in mind that cars eventually wear out, and over the last two-plus years, new supply has not kept pace with underlying consumer demand.
We are less sanguine on housing, to include the rental market, which appears ripe for a correction. The median house price increased some 36% over the last two years, to a record $440,000. Cheap borrowing costs, of course, translated directly into higher home prices. A second factor is the impact of remote work, which pushed housing demand into secondary markets. Since the Fed’s rate actions, 30-year mortgages have moved to over 6%. We believe it is only a matter of time for prices to soften and move back toward greater affordability.
We continue to monitor the economy and investment markets closely, and to align client portfolios with our thinking. Markets have corrected this year, giving back valuation (price), despite underlying earnings grinding higher. Fed rate policy will remain a headwind until there is a clearer outlook for inflation, which we believe is in the offing—slowly, and not in a straight line, but on its way. In the meantime, our investment strategies remain focused on quality and durable investment ideas.
In our flagship Ascent Dividend Focus strategy, we have continued to migrate to a slightly more defensive posture of late, increasing our exposure to health care and similar defensive themes, while at the same time reducing our technology and consumer discretionary exposures. Similarly, we reduced exposure to higher-valuation growth equities in our Global Growth strategy, and introduced new ideas in real estate, water treatment, and semiconductor testing equipment, among others. We remain pleased with our value-focused Income portfolio, featuring above-average dividend streams and generally defensive positioning. As the Fed has continued its rate hikes, we have been investing in steadily stronger yields in the fixed income space. Last, for our accredited investors, we continue to source new investments in the Alternative category, offering our clients diversification away from the daily volatility of the public markets.
As seasoned investors, we know that opportunities present themselves in moments of adversity, and we continue to work with your interests in mind. We thank you, as always, for your continued confidence.