Highlights:
· Five of the largest central banks in the world came to five different conclusions during the quarter regarding inflation and interest rates.
· Attempting to time interest rates is no easier than timing equity markets and is not recommended. Economic growth and corporate profits drive long-term returns.
· Patient investors who are able to tune out the noise will continue to prosper longer term, where equity markets have historically had a tendency to go up.
Commentary:
“In economics, things take longer than you think they will, and then they happen faster than you thought they could.”
-Rudiger Dornbusch, Economist
Look no further than today’s inflationary environment an example of this quote. Ultra-accommodative central bank policies had investors convinced inflation was inevitable as early as 2010. Naysayers of these loose policies were eventually proven correct, but not until 2022, and even then, it took a global health pandemic and a European war to jump-start inflation. However, once inflation took hold, it went from zero-to-sixty and led to central banks embarking on an aggressive rate-rising campaign.
The developed world’s central banks are now faced with quite the quagmire. They need to determine if inflation has stalled above their 2% target, which may require still higher interest rates to bring down, or if a decline in inflation is simply delayed because previous hikes have not yet worked their way through the economy. Having mischaracterized the rise of inflation as transitory in the first place, the stakes are high for central bankers to make the right call this time around so they don’t push the global economy into a deep recession or force it to endure years of high inflation. This may require central banks to wait long enough for past interest rate increases to filter through the economy without underestimating inflation as they did in 2021.
Nevertheless, it is fair to say at this point that the normal impacts of rate hikes have not slowed economies nearly as much as expected since central banks began racing at a lightning fast pace last year to cool inflation. This is likely attributable to the unusual nature of the pandemic-induced 2020 recession and the ensuing recovery. During this time, governments provided households and businesses with trillions of dollars in financial assistance at the same time as they were saving money because the pandemic disrupted normal spending patterns. Households were also able to lock in low borrowing costs because of central banks’ rock-bottom interest rates at that time.
These savings allowed consumers to splurge on activities they missed during the pandemic, such as dining out, travel, and concerts, while businesses have had to hire to satisfy this pent-up demand. This created a pandemic-induced labor shortage, which led to solid wage growth as businesses needed to compete for workers. This wage growth has allowed many households to replenish the coffers after running through pandemic-driven savings. This is a vicious cycle whereby higher wages for consumers fuels spending, which puts upward pressure on inflation. This is the reason many investors believe that bringing down inflation to historical norms will remain difficult, if not elusive, until there is some semblance of normalization in the labor market.
Strains in the banking industry, following the collapse of three midsize lenders during the spring, have also put the U.S. Federal Reserve in a difficult situation. Raising rates significantly more would put even more pressure on banks. At the same time, they do not want to risk inflation becoming self-perpetuating to the point it becomes engrained in public psychology, which could lead to short-term interest rates remaining higher for longer. This dilemma played a large part in why the Fed held off on raising interest rates at its June meeting for the first time since its campaign to curb inflation began 15 months ago, ending a streak of 10 consecutive increases.
However, they did signal two more increases were likely this year, which would bring U.S. rates to a 22-year high. Fed Chairman Jerome Powell opined at the June meeting “inflation has moderated somewhat since the middle of last year. Nonetheless, inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go.” Powell went on to say later that, “if you look at the data over the last quarter, what you see is stronger than expected growth, tighter than expected labor markets and higher than expected inflation…although policy is restrictive, it may not be restrictive enough and it has not been restrictive for long enough.”
The direction of the labor market will likely play a large role in determining if the Fed follows through with raising rates later this year because the Fed sees normalizing the tight labor market as a necessary step in reducing inflation. Through May, the U.S. economy has added more than 1.5 million jobs in 2023, which has resulted in the number of open jobs still far exceeding the available labor pool. If the job market continues to be strong, it is likely that there will be continued strength in wages and consumer spending, both of which typically contribute to higher inflation.
Although the Eurozone entered a technical recession during the first quarter of the year, they still added almost a million new jobs during this time. The European Central Bank (ECB) increased rates by a quarter percentage point at its June meeting and ECB President Christine Lagarde stated “we are not thinking about pausing,” at least through the summer, because “inflation has been coming down, but is projected to remain too high for too long.” Like the U.S., interest rates in the euro area are now at a 22-year high. Also similar to the U.S., a robust labor market, a historically low unemployment rate, and strong wage growth continue to put upward pressure on core inflation.
The U.K. has thus far avoided a technical recession due to an unexpected rebound in growth. As recently as a couple of months ago, the Bank of England (BoE) had shown an inclination to pause its long series of interest rate hikes. However, sticky wage and consumer price growth prompted the BoE to raise its key interest rate for a 13th consecutive time at its June meeting to a 15-year high. Furthermore, the BoE raised its rate by half a percentage, which was a more aggressive increase than its developed market counterparts. This was driven by the U.K. having one of the highest current inflation rates amongst the wealthiest developed countries. On the plus side, while growth is likely to remain subdued, the BoE no longer forecasts a recession due to lower energy prices and better demand.
On the other side of the coin, China does not have an inflation problem, but likely wishes it did. Optimism that the world’s second largest economy was rebounding sharply since lifting strict Covid-19 controls have been replaced by suffering from the repercussions of those extended lockdowns, as well as a property bubble. With its people starting to lose faith in the economy, senior officials took abrupt action to stimulate the economy, despite the risks of encouraging speculative behavior that China has aggressively been trying to eliminate. Specifically, China’s central bank cut three policy rates to help encourage lending. The government is also considering issuing up to 1 trillion yuan ($140 billion) in special treasury bonds to help fund new infrastructure, and loosening rules to encourage people to buy more than one home.
It would appear that Chinese leaders realize that restoring confidence in the economy is necessary to avoid a deflationary spiral, which is typically immune to monetary policy and stimulus measures. Confidence is especially fragile amongst the youth population, where the unemployment rate for Chinese aged from 16 to 24 rose to a record 20.4% during the quarter. China is well aware of what happened in Japan in the 1990s, when weakened confidence after a real estate bust led to decades of weak growth and declining prices. Households and businesses appetite to borrow amid already high debt levels and subdued prospects for growth will likely determine the extent to which additional stimulus might be necessary.
Speaking of Japan, there is hope that they are pulling free from three decades worth of deflation and are on a path toward sustainable inflation. This optimism is rooted in recent price increases for services such as lodging and movies, which tend to reflect higher wages, whereas the prices of goods tend to fluctuate with energy costs and foreign exchange rates. This theory is backed up by recent wage negotiations that resulted in the biggest pay raises in three decades at some major Japanese companies. For now, the Bank of Japan indicated that they plan to nurture these recent positive developments by continuing with their policy of monetary easing.
To conclude, five central banks came to five different conclusions during the quarter. The U.S. is on hold, the Eurozone is continuing to raise rates at a 0.25% clip, the BoE bumped its increase to 0.5%, China is cutting, and Japan is maintaining the status quo of monetary easing with an eye toward sustainable inflation, something that has eluded them for over three decades. Hence, it is really no surprise that the tug-of-war between central banks and investors continues to be a central theme for 2023.
Equity markets have bounced back from last year’s lows based largely on resilient consumer spending and the perception that central banks are nearing the end of the current rate-rising cycle, and might even lower rates soon to avoid a deep recession. We believe this is presumptuous. Higher rates have somewhat cooled the economy, but have not ended the economic expansion either. Recent economic data in many parts of the world show resilient and growing economies, while the deep recession that many economists predicted has so far remained out of sight.
We do not attempt to time interest rates any more than we do equity markets, but we do believe that the days of highly accommodative monetary policy are likely over and we have entered a different environment, at least for the near future. If this turns out to be the case, it is reasonable to extrapolate that equity market returns will be harder to come by going forward than they were during the longest bull market on record that occurred from 2009 through 2021, in what many analysts have coined a rising tide market. Howard Marks of Oaktree Capital Management recently opined that:
“An environment where everything’s easy isn’t a healthy environment, because it encourages risky behavior and bad habits. I always say the riskiest thing in the world is the belief that there’s no risk. I believe that’s over, and I believe we’re heading into a more normal period, where nothing’s as easy as it has been for the last several years. But it’s a healthier environment, because people will be applying an appropriate amount of risk aversion, as they should.”
It is easy to be caught up in the future direction of interest rates, but it is important to remember that what really matters for long-run returns is economic growth and corporate profits. Markets are likely well along in pricing in sticky inflation and higher rates, although it remains uncertain how long it will take previous interest rate increases to hit the economy. The crash narrative is always going to be good for media ratings, but the long-term upside of the stock market greatly outweighs the downside. The stock market does crash from time to time and it will crash in the future, but the world is not always going to end, as the media would have you believe.
From an investment perspective, it is nearly impossible to predict when these crashes will happen and how long bear markets will last. Carl Icahn, a billionaire investor, has been positioning his portfolio for a crash since 2017 and it is estimated to have cost him almost $9 billion. He recently told The Financial Times, “I’ve always told people there is nobody who can really pick the market on a short-term or an intermediate-term basis. Maybe I made the mistake of not adhering to my own advice in recent years…I obviously believed the market was in for great trouble, [but] the Fed injected trillions of dollars into the market to fight Covid and the old saying is true: ‘don’t fight the Fed.”
The investment policy we espouse prepares for downside risk in the stock market by insulating portfolios on a rolling basis with cash and fixed income exposure intended to meet projected withdrawal requirements for approximately nine years. This enables the balance of a portfolio to participate in the upside in the equity markets, which historical data show almost always go up over the long-term. Pessimism may sound smarter than optimism, but prudent investors know that patience usually wins out in the end.
Urban Financial Advisory Corporation – July 2023
Disclaimer:
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