Central bankers wary of triggering a bear market

U.S. Fed’s new hawkish tone as inflation hits 39-year high

The Chair of the U.S. Federal Reserve Board (the Fed), Jerome Powell, admitted recently that inflation was no longer “transitory,” that is, no longer a short-term, temporary phenomenon. This will not come as a surprise to many investors and analysts. The real surprise is that the Fed and other central banks, such as the European Central Bank (ECB) and the Bank of England (BoE), should have kept claiming that inflation would rapidly decline beginning in early 2022, when a number of factors mean that it will likely remain higher for longer.

One of the major components of the U.S. Consumer Price Index (CPI) is intended to reflect the cost of housing. In the U.S., unlike in many European countries which use actual rental costs, the index uses what is known as “owners’ equivalent rent” (OER), which looks at what it would cost to rent a home, and which comprises 34% of the CPI. Therefore, OER reflects the rise in the price of houses with a 12 to 18 month lag. Given the median U.S. house price has increased by 18% in the 12 months to the end of October. This implies CPI will rise by nearly 6% in 2022-23, even if there no increase at all in food, energy, or other prices.

Inflation growing globally

With U.S. CPI up at an annual rate of 6.8% in November, the highest rate in 39 years, and by 4.9% in the Eurozone, and 4.2% in the U.K. in October, it’s evident that inflation is a widespread phenomenon globally. Specific issues such as oil prices doubling over the last year, the shortage of microchips for automobiles and consumer electronics, and disruptions to supply chains caused by reduced capacity during the first wave of the pandemic are contributing to these very rapid increases.

Some of them will doubtless prove to be genuinely “transitory” in that the production of chips will increase, more ships and containers will be put into service, and congestion at ports will improve. The largest port in the U.S., Los Angeles/Long Beach, moved to 24-hour/7-day a week operation recently, which will undoubtedly help ease some of the bottlenecks caused by a massive increase in demand for goods.

However, as the arrival of the Covid-19 omicron variant has demonstrated, demand for services such as travel, hospitality, and events remains vulnerable to new interruptions, as airline routes are suspended, lockdowns reintroduced, and consumer confidence receives another blow. With large amounts of cash in their bank and brokerage accounts, and fewer experiences in the service sector to spend it on, consumers have logically responded by buying more physical goods, which increases price pressures and makes shipping expenses and bottlenecks worse.

Furthermore, what has been called the “Great Resignation” by older workers who have not returned to the workforce after the lockdowns ended has only aggravated a shortage of workers, which is leading to rising wages and more pressure on company margins. Mr. Powell indicated he believed that “to get back to the great labor market we had before the pandemic, we’re going to need price stability…the risk of persistent high inflation is also a major risk in getting back to such a market.”

As a result, the Fed is considering accelerating its tapering of purchases of government and mortgage debt, down from $15 billion a month in November and December. This could mean that quantitative easing (QE), which has been supporting the bond and equity markets since the pandemic began in March last year, could be withdrawn by the first quarter of 2022 and short-term interest rates could start rising as early as the second quarter.

Bull markets don’t usually end because stocks have become expensive, but because the supply of liquidity starts to diminish, either because the central bank is no longer supporting the markets through purchasing bonds or because the price of money, as represented by the interest rate, begins to rise.

Investment implications

While the North American indexes are still near all-time highs, even after the omicron-induced panic sell-off in late November, the number of stocks hitting new highs has been diminishing since early this year. Technology giants of the FAANG+ group (Facebook, now calling itself Meta), Amazon.com, Apple, Netflix, Google parent Alphabet, and Microsoft) and electric automaker Tesla dominate the indexes, comprising over 23% of the S&P 500 Composite Index by market capitalization.

While the Nasdaq Composite Index is up 21% and the S&P 500 ahead 25% year-to-date on IT advances, most other companies are either flat or even down somewhat. With government regulators and European authorities imposing fines and considering whether to break up these tech behemoths, quite apart from their high valuations, investors would be well advised to take some their profits in these companies, after consulting their financial advisor.

Sectors that have done well, yet remain good value, and that are no higher than where they were five years ago include traditional energy companies (for example, BP, Shell, ExxonMobil, Chevron, Eni), and pipelines (for example, Enbridge, TC Energy, Pembina Pipeline), materials stocks, including gold miners (such as BHP, Rio), telecommunications and entertainment companies (e.g., AT&T, Vodafone, Verizon, Viacom), REITs and consumer discretionary plays such as Anheuser Busch and BAT. Almost all of them also pay dividends, which are higher than government bond yields and which increase with inflation.

Gavin Graham is a veteran financial analyst and money manager and a specialist in international investing, with over 35 years’ experience in global investment management. He is the host of the Indepth Investing Podcast.

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