Market volatility has always been difficult to stomach. If you get the feeling that this time around feels a little different, you’re on to something. Our steady friends in the bond market, did not provide much stability this time around, as stocks turned lower, bonds have as well. The drop in stocks and treasury bonds in April 2022, is a feat we’ve only see four times in the past 49 years.
Source: Deutsche Bank
So how did we get here and what happens next?
Why is the market going down? The short answer is inflation, but how inflation occurred is worth exploring. Inflation is caused by an imbalance between supply and demand. Coming out of the COVID pandemic, expectations were that inflation should wane as economies re-opened and supply came back online. Fast forward two years later, COVID is still a prevalent challenge for supply chains (see China’s zero tolerance COVID policy lockdowns), and now we’re witnessing a war in Ukraine.
Supply Side:
The supply side of the inflation dynamic has many sides worth discussing. Notably we’re seeing constrained supply in oil (and commodity) markets, food (attributable to the Russia/ Ukraine War) and goods due to the China COVID lockdowns. Goldman Sachs Global Research breaks down the impact of commodity prices on inflation:
While the chart is somewhat technical, it helps us cut through some of the noise to see the roots of inflation are largely in energy. On the goods side of the equation, while congestion in U.S. ports has improved over the past month, this chart of the port in Shanghai shows us the impact of the COVID lockdowns. The red line shows the spike in port congestion and the blue line shows us the flow being processed grinding lower.
Source: Gaode, Baidu Maps, TS Lombard
Demand Side:
If we look through the lens of the flow of money, we see that the global economy has seen significant money creation:
Source: St. Louis Fed (FRED)
This chart shows us the increase in the Federal Reserve’s balance sheet since 2010. As you can see, it has nearly doubled since then, with substantial increase in 2020 from the COVID policy response. We have seen this type of increase across the globe in major economies (Europe, Japan, etc). This has created an environment where we see large dollars seeking few supplies – which brings us to inflation.
We’ve highlighted a few of the macro economic supply and demand themes that have impacted the global economy, however, as we often say the stock market and the economy are different things, as counterintuitive as that may seem. So, what is causing the market volatility?
Shock and Surprise
The development of a war that involves a major energy producing nation has created uncertainty in an already a delicate global economy. If you take a look at this chart, we can see the EU is going to struggle to balance their energy policy with Russia as it’s plan to replace Russian gas has yet to materialize.
This has led to a more pronounced jump in inflation in the EU as a result of energy scarcity. Adding additional energy capabilities takes time, money, and political capital. It remains to be seen how much of those inputs the EU (or the globe) has at this time.
Varying Global Responses
United States:
The US approach, which has been communicated by the Federal Reserve, is focused on an increase in interest rates combined with a reduction of the balance sheet. What does this mean? In short, this is a tightening of financial conditions and has a lot of implications, one being mortgage rates.
Source: Freddie Mac
This makes housing less affordable, and will serve as an ice bucket over what was a scorching hot housing market the past few years. The reaction will be reduced demand for housing and prices will moderate from the lofting increases that we’ve seen the past couple years. In effect, this action is reducing demand to meet supply. While it does not feel great, this is the ‘medicine’ for inflation.
Europe:
The response to inflation in Europe is a bit more complex. The European Central Bank (ECB) has been actively purchasing government bonds since the great financial crisis to help support its member’s economies. While the ECB has discussed reducing net purchases and have hinted at possible rate hikes, it is still unknown just how far it will be able to go to stem the inflationary pressure in the same way the US (and the Fed) have. The Russia/Ukraine war only adds more pressure to inflation through energy dependency as they are faced with choices of sanctions against Russia and supplying energy for their people.
China:
China is in a different situation than most of the globe for a number of reasons. First, their zero COVID policy of robust lockdowns when cases appear has led to their economy being subject to continual interruptions. This has an impact both on supply of goods and demand by their consumers. In some cases, people have not been able to leave their homes for weeks. Secondly, China’s response from the onset of the pandemic was not to cut interest rates. Only recently have they begun doing so, just as most other economies have started to hike their rates. Finally, China has throttled some industries through increased regulation in an attempt to control the growth and influence of the corporations – one example of where you see this is throughout their technology sector.
Japan:
The final economy we’ll look at is Japan. Japan has been tightly controlling their interest rate policy for decades. The reasons for why they do this are long and are structural for their economy. As a policy, the Japanese Central Bank (JCB) has set their target 10-year bond rate to 0.25%. While they have seen inflation as well, their policy has been to not change their policy at all. The results can be seen in the jump in the currency exchange been the yen and the dollar.
Source: St. Louis Fed (FRED)
What does this mean? To bring it home to the US, Japan has been one of the largest purchases of US Treasury Bonds. With the large divergence in currencies, it makes US treasuries unattractive to the Japanese on a hedged or currency adjusted basis.
What all this means for markets:
More stress. Low interest rates have led to high valuations in much of the ‘growth’ parts of the global equity markets. The challenge for the US market is if we look at the top companies in the S&P 500 today, the valuations of these companies have taken off. As interest rates have increased, it has brought selling pressure to bring valuations back ‘in line’.
Source: JP Morgan Asset Management
In the bond market, as we explored earlier, the stage is set for the Fed to continue on the path to increasing interest rates. The thing to remember is markets are quick to price in expectations. We currently see the 2-year treasury yielding 2.71%, meaning much of the increases have been priced into market already. As we move forward, the direction of rates will depend on data around inflation. Inflation can be moderated two ways – increased supply or decreased demand. The ‘best outcome’ comes from increasing supply, however, supply improvement takes time.
We have not had many rate hiking cycles in the past few decades, but here is a look back at some of those periods and how sub-asset classes have performed relative to the median.
Source: Vanguard
Is there a Bright Side?
Change comes fast. A lot of negative impulses have been priced into the market. As some stress lowers, often things getting ‘less bad’ can lead to meaningful turnaround.
China COVID cases are coming down
Source: NHC
The hope here is this will ease lockdowns and help with restoring supply to the market.
Corporate Buybacks
Goldman estimates S&P 500 buybacks to increase 12% in 2022. This represents a major source of demand for US Stocks. In 2021, we saw buybacks over $1.2 Trillion on buybacks. Below is a chart that shows a rolling 12-month chart of buyback announcements.
Source: JP Morgan
What should you do?
Have a plan for your assets and understand your time horizon. The more time you have, generally the more risk you can take.
When investing in this environment, we believe valuations matter. Companies with strong balance sheets, solid earnings prospects, and maybe even a dividend can provide a smoother ride.
Remember good financial decisions can be made in poor markets. Here are a few:
Tax loss harvesting
Roth Conversions
Estate Planning
Investing idle cash if your plan deems it appropriate
The information explored today, is intended to educate and inform on the current market climate. As data and news flow change Cassady Schiller Wealth Management’s process allows for a steady hand to provide context, clarity, discipline, and a plan to improve your financial life in all market conditions. If you or someone you care about have questions we are happy to assist.
DISCLOSURE: The information contained herein has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy. Cassady Schiller Wealth Management is a registered investment adviser. Registration does not imply a certain level of skill or training. Information presented is for educational purposes only, are subject to change from time to time and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
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