Putin, Powell, Pandemic and Politics
There are four Ps which have contributed to the recent stock and bond market decline. In no specific order they are Putin, Powell, the Pandemic and Politics.
The clear focus right now is on Fed Chairman Powell. Powell’s problems are the peskiest and a direct result of all the other three Ps. Chairman Powell is in the unfortunate situation of trying to tame inflation without stunning the economy. Strategically raising the Fed Funds Rate is part of the playbook here. This demands drawing a fine line between raising the cost of overnight lending (and pushing longer term rates higher) and preventing the U.S. from sliding into recession. The idea is to slow down demand enough to reduce inflation pressures without hampering the ongoing supply recovery. Headline year-over-year inflation through April came in at 8.3% (down from 8.5% in March) and is now just below its 40-year high. The Fed has a lot of work to do and accomplishing this task perfectly would be like summersaulting off parallel bars and sticking the landing without wavering.
U.S. Inflation Rate
Many would argue that Powell has made this problem more difficult by ignoring spiking inflation in 2021 and continuing to stimulate the economy with low interest rates. By keeping his foot too long on the gas pedal, Powell might have fueled his own inflation fire. The good news here is that he is working with a fairly strong economy underpinned by record job vacancies and a consumer with historically low debt and a higher net worth than pre-Pandemic levels. He might not have to stick his landing perfectly.
The remaining Ps—Putin, The Pandemic and Politics—are reasons why prices continue to rise. Putin’s invasion has made already surging energy and food prices even more troublesome. The Pandemic, along with China’s zero-COVID policy, persists in interrupting supply chains. Fiscal policy (Politics) which poured trillions of stimulus dollars into the economy has driven up demand and so prices and wages. All these contributed to higher inflation and now higher interest rates as the Fed begins to respond. Rising interest rates, and the increased risk of recession, have triggered investors to reassess stock exposure and shifted company valuations as many rebalance just to be safe. Inflation inputs—materials, parts, labor—makes future earnings more challenging to achieve for corporations. If future earnings are threatened, then stock prices need to be adjusted lower to reflect potentially softer profits. Some companies are able to pass those cost increases into prices—and those companies will see sales and earnings keep up with inflation. But there is a second impact of inflation on stock valuations: higher interest rates reduce the present value of those future earnings. If an investor saves ten bucks of earnings today, the higher interest rate means it will be worth well more the ten bucks next year. So ten bucks of earnings next year simply isn’t worth as much as it was with low inflation and interest rates. The more a company’s market valuation is out of whack with estimated future earnings, discounted by those higher interest rates, the more a company’s stock price needs to fall. This is why some of the Pandemic perfect tech stocks have come down the most.
The good news is that all these Ps are not permanent. Even the politics.
Markets correct sharply when there is not enough information to figure out how perfect the landing might be. And right now, the stock market doesn’t know to what extent inflation will remain in the system or when Powell can tame inflation without putting the economy into recession. There are additional risks on the table with the war in Europe and the wondering about Putin’s next move. All these Ps are ripe and in the moment. But they are not permanent. Including congress. Elections every couple years allow Americans to asses fiscal policy and potentially pivot. Markets assess risk and then rebalance until some or all of the risk begins to dissipate. This market would welcome any one of these Ps to roll off the table. But at least for the moment they are all front and center.
So here we are. For the first time since the spring of 2020 the economy recently had negative growth. In addition, the 10-year treasury yield has reached 3% for the first time since 2018. After decades of little or non-existent inflation, the stock market is dealing with higher inflation and rising rates. What has made matters a bit more troublesome for many investors in that their bond holdings have been unable to be the ballast of their portfolios.
If higher interest rates stress stock markets, they are kryptonite to bond prices. The reasoning is as follows: suppose I buy a 3% bond today and next month there are 4% bonds coming to market. No one is going to buy my 3% bond unless I lower my price to increase the yield. Of course, other factors such as the investment quality and duration of the bond can make the situation even worse. Having to sell bonds in a rising interest rate environment is almost ensuring a paper loss right now becomes a realized loss and the size depends on all these factors. Buying individual bonds for our clients allows us to control what we buy and how long we want to hold it and this helps to mitigate interest rate risk for our clients.
Until the markets get some more guidance regarding Putin or Powell’s next moves or see diminishing inflation, high valuation stocks will continue to be in the dog house. The good news is that much of those negative expectations has already been exposed. Markets tend to over sell just to be safe. And in our opinion the broader stock market (minus certain higher valuation tech and consumer stocks), which was not overly expensive before this recent correction, now looks very attractive.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.
