By Paul Broughton, Portfolio Manager
The current backdrop that the markets and the economy are facing might feel to many that we’re in “another fine mess” to quote Laurel and Hardy. Inflation is at a 40-year high and expected to rise further in the months ahead. The S&P has dropped by more than 8% since reaching an all-time high on Jan 3rd. The Nasdaq Composite reached bear market territory – declining by 21.6% from it’s high in November to Mar 14th. The Treasury curve has been experiencing a bear-flattener (where short-term rates rise faster than long term rates) since March of last year. And the world gets to watch in horror the very dangerous war in Ukraine happen in real-time. What should investors be thinking about with all of this in mind?
Inflation should remain the Fed’s primary economic concern. Indeed, this past week the Fed raised rates for the first time since Dec 2018 and indicated that they are likely to raise rates six more times this year – this would put the Fed Funds rate at 1.75%-2.00% at year-end (if they raise by 25 bps each time). What’s interesting about the beginning of this rate hiking cycle is that it’s happening in the face of quite a bit of turbulence in the markets, there’s a war going on in Eastern Europe that could escalate or spread, and the Treasury curve is rather flat. With all of that being said, it illustrates how important it is for the Fed to get control of inflation before it becomes entrenched in consumer expectations and the economy. This is the opposite of the Fed providing accommodation to save the markets during heightened bouts of uncertainty and volatility. Russia’s war on Ukraine has slowed economic growth prospects and raised inflation. Now the economy is faced with the prospects of higher-for-longer energy and commodity prices. Even if there’s some sort of resolution to the Ukraine war, it’s very likely that countries will look to secure energy and commodities from more reliable sources in the months ahead. The US daily national average gasoline price, according to AAA, stands at $4.27. This is remarkably high when compared to the five-year average of $2.64 (the highest in the country is California’s average price of $5.80). And since food, energy, and housing comprise the biggest shares of wallet spend for most Americans, discretionary spending for many in the US will likely slow in the months ahead. Before the Russian invasion, it was hoped that the receding Omicron variant in most of the world would lead to improvement in supply-chain issues. The war and a resurgent Omicron in Asia, however, have delayed for now, at least, some of the hoped-for improvements in supply chains. This likely means further pressure on inflation.
At Chairman’s Powell post-meeting press conference, he spoke clearly to the strength of the economy and the very tight labor market. This is an important and maybe somewhat subtle point: because the US economy is strong and healthy and is at, or very likely close to, full-employment, it creates a relatively strong backdrop to afford the Fed the ability to embark on a well-telegraphed rate hiking cycle despite the current state of uncertainty in the markets and the geopolitical scene. The Fed is willing to slow economic growth in order to tame inflation now and they likely feel that they have the latitude to do so due to the very tight labor market.
Stepping back and looking at the market’s current valuation, it’s important to keep in mind that, despite a global health pandemic with two problematic variants and now a war in Europe, the S&P 500 is up 41.2% since 12/31/19 (before Covid). This represents a 16.9% annualized gain. The S&P 500 is currently trading at 17.9x next year’s earnings. At the end of 2019 it was 18x. In other words, the market appears reasonably priced. This suggests that staying invested and looking beyond the headlines is the best path for investors despite all of the news that can be very unsettling.
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