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In hindsight it seems obvious that the good times would end. In the last two years, it had become too easy for investors. The record amount of cash sent out by governments and central banks to fend off the pandemic’s economic impact found its way into every investible asset class. After two straight years of double-digit returns in equities and all risk assets flying, the term “everything bubble” was coined.
But all bubbles must deflate at some point, and that’s what we’re going through this year. The headlines are all screaming about how we had the worst start to an investing year since 1970 and that the largest amount of capital was destroyed in history, but all this needs to be put into perspective as we came into this year on a sugar high that needed to be reset.
We all knew that there has been too much excess in the economy in the last few years. The rise of SPACs, spec tech, and NFTs proved that money was too easy to come by, and to earn a return, the economy was willing to go to areas of extreme risk. Like all manias, this came to a crashing halt once the tides turned, and the days of easy money ended.
Central bankers are finally admitting that they are “behind the curve,” meaning that they know they waited too long to adjust policy and combat inflation. Last month, the U.S. Federal Reserve Board’s Federal Open Market Committee hiked the Fed Funds rate by 75 basis points (three quarters of of a percentage point), which is the largest increase since 1994, signalling that they are finally serious about addressing inflation.
In normal times, the Fed Funds rate and the U.S. CPI are at similar levels. It's striking when you look at it today as the U.S. CPI is over 8% while the Fed Funds rate is at 1.75%, with a target of 3.5% by year-end. That spread is the largest on record and needs to be addressed. This of course can be achieved in three ways: more rate hikes; inflation coming down on its own; or through a combination of the two. Central banks have been talking about “transitory inflation” for a while now as supply chains took time to adjust from the lockdowns, and we will get to test that theory soon. If that’s the case, we may be starting to see peak inflation, but it’s too soon to call it.
During the month of June, it seemed like there was a constant battle between the fears of inflation and the fears of a recession. In the earlier months of the year, inflation worries allowed real assets, such as energy, to perform very well and show impressive gains. However, as we switched to fears of a recession, commodity and asset prices took a hit. Energy stocks, which had been the only hiding spot for the year, ended the month off 16.6%; however, they are still positive on the year, meaning this may in fact be a tremendous buying opportunity.
We may also be entering a period of the economy where bad news is actually good. The stock market remains incredibly tied to central banks. The old adage “don’t fight the Fed” has never been more apt. While central banks are now willing to accept a recession in order to slow inflation, if they are successful and achieve that result, they may be able to adjust to a more neutral stance earlier than expected.
That will be the most important question to answer in the second half of the year.
The selloff that has hit risk assets so far has really been all about a contraction in valuation multiples. The next fear is that earnings will have to be adjusted lower. It would be hard to imagine a scenario where the economy goes into a recession and S&P 500 earnings don’t contract. This will be important to watch for July.
However, as we have previously mentioned, if there are too many signs of weakness from consumers, we may see a tone change from central banks. Bond yields have already picked up on this, as the U.S. 10-year bond yield is well below its high of 3.5% from a few weeks ago.
So far in 2022, there has been nowhere to hide. Fixed income, which is normally a diversifier in balanced funds, is down, and bond investors are losing money for the first time in years. Everyone knows the bear case for stocks, but what will be interesting to watch for the balance of the year is what will happen when things begin to turn. Financial markets are forward-looking in pricing terms – if you wait for the absolute peak in inflation, it will be too late. It may be time to become a contrarian.
It hasn’t been a good start to the year by any measure. We still need to have markets become more comfortable so that central banks have a handle on inflation, but once that occurs, there could be a nice recovery. Sentiment indicators are showing signs of capitulation from many investors, which is what you need to see for a bottom.
So, are we there yet? Maybe not today, but I would be much more comfortable putting cash to work at these levels than last December when everything felt priced for perfection.
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
Notes and disclaimer
Content copyright © 2022 by Purpose Investments Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Macro commentaries” page of the Purpose Investments’ website. Used with permission.
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