“THE only function of economic forecasting is to make astrology look respectable.”
-- John Kenneth Galbraith (an economist!)
The first half of this year has felt like one of the hardest challenges of my 26 year career. Not the same as the Great Financial Crisis or the European Crisis or the early days of Covid, but those were all periods of actual crisis! So why are investor sentiment numbers worse now than during those times? Why did the Michigan Consumer sentiment survey print an all-time low recently? Where is all of this negativity coming from?
Yes, inflation is running at a 40 year high. Yes, interest rates have to go up to fight inflation so for those living paycheck to paycheck or for those who are overly indebted, negativity and fears are warranted. But I think it is more likely that the market believes that we got through Covid too easily and things were about as good as they could possibly get. Then Ukraine hit like a sucker punch and drove food and energy prices much higher than were expected and highlighted just how hard it is to predict our modern world. As Niels Bohr the Nobel laureate in Physics is credited for saying, “Prediction is very difficult, especially if it’s about the future!”
As hopefully all reading remember, I have been in the inflation camp long before it got crowded. So you can imagine how frustrating it is to have seen much of this inflation ahead of time and still not be able to scramble to sufficiently higher ground to avoid all of the carnage. Every asset under the sun is priced off of interest rates and with rates soaring this year due to persistently high inflation, all asset valuations have come under pressure. In fact, the only thing that has appreciated so far this year is the U$ and a strong U$ is really not good for anything except the U$. American corporations that sell overseas bring back less valuable earnings so US profits come under pressure. And a huge portion of the $300 TRILLION in debt obligations around the world are denominated in U$, these obligations become more onerous. A stronger U$ effectively exports inflation to other countries with many of these countries far less able to withstand the higher inflation. While a stronger U$ will help tame US inflation, it will exacerbate inflation and unrest in other countries. Sri Lanka is by no means a model situation but it is likely just the first country to experience civil unrest and devastated finances. So stress is building very quickly behind the scenes and this stress is in fact adding to the strength of the U$ as it is seen as a safe haven in difficult times. Something has to give and I think it will give sooner than later. I think we are in the process of seeing peak U$ now. On only 2 other occasions (inflation adjusted that is) has the U$ been this high.
Clearly the strength in the U$ is because the US Federal Reserve has declared unconditional war against inflation and is leading the charge by raising the US overnight interest rates most aggressively in over 20 years. In response, the all-important US 10 year treasury benchmark yield has doubled since the start of the year from 1.50% to 3.0%. It is not the absolute level of rates that is of concern but the rapidity of the ascent. Clearly inflation was not transitory like all the central banks believed it was last year when they all kept rates too low and the cheap money around for too long. And certainly the Ukrainian war added additional inflation to the mix. That said, in addition to a peaking U$, I think there is a good chance that we are witnessing peak inflation also as all commodities started to tumble in price rather stunningly over the last couple of months. Corn and wheat prices are back to where they were at the start of the year and gasoline futures are down now 30% in a month. While lower commodity prices show that the fight against inflation is working, their dramatic collapse is causing the market to shift from the inflation concern to a recession narrative. Behind door number 1 is excessive inflation and behind door number 2 is a recession! Talk about pick your poison!
Remember that the stock market looks forward 6-12 months so it has spent most of this year discounting the likelihood of a recession caused by higher interest rates. It effectively has priced in about 2/3rds of a typical recession already in that stock markets historically fall by about 30% during an average recession. Major indices like the S&P500 are now off 20% with the Nasdaq off over 30%. And closer to home, the TSE which had held in so much better until spring due to our commodity exposure, has now been rushing to catch up over the last 2 months. It has been a brutal 6 months and in fact the 3rd worst first half of the year on record for the US markets.
At times like this, all good news is viewed through the prism of this sour mood and there is some good news which never gets airtime. For example, employment remains very robust and it would certainly be unusual for a recession to happen when everyone who wants a job has one. But in this market, that is just being interpreted as future wage inflation. Consumers and corporations are flush with cash and perhaps in another time, the market would appreciate their resiliency. Canadians entered Covid with about $40 Billion in bank account balances and that is now over $300 Billion. In the US that number is almost 10 times larger. Companies took advantage of record low interest rates and raised cash and also extended their debt maturities. These are good underpinnings but the media refuses to acknowledge these facts because it doesn’t keep viewers tuned in after the commercial break!
So if inflation really is in the process of peaking, much of the work (or damage) has already been done and I suspect the Federal Reserve (and the Bank of Canada) will begin to moderate their stance by September and let higher rates percolate. So what we need now is time. Time to let the higher interest rates change behavior and time to allow for inflation to catch up with tighter monetary conditions. While the Federal Reserve has a dual mandate of maximizing employment and targeting 2% inflation rates, they have to acknowledge that these 2 measures are notoriously lagging in nature. So with one policy mistake in the books, I have to think they are not going to drive down the road only looking in the rearview mirror. The Fed has over 300 Economists with doctorate degrees on staff and they all got it wrong last year. I may be giving them too much credit, but I really don’t think they want to get it completely wrong again and cause too much pain or worse, risk a financial contagion emanating out of the emerging Market economies.
Remember, markets don’t bottom when news improves, they bottom when the news is less bad than expected and we have priced in a lot of bad news this year.
As always please feel call to call anytime!
Derrick