The Silent Factor

“The ability to distinguish between volatility and loss is the first casualty of a bear market.”      – Nick Murray, Author of Simple Wealth, Inevitable Wealth

US Stocks officially entered a bear market on June 13th when the S&P 500 closed 22% below its January 3rd high. We’ve been here before.  Only two years ago, Covid-19 caused a panic in equity markets which led to a more than 30% market decline. Those losses were (relatively) quickly reversed as investors realized that both Congress and the Federal Reserve were quickly acting in their favor. Easy monetary policy supported what we can now clearly see, in hindsight, was a speculative market bubble that continued for another two years.

We enter the summer with the Fed taking strong action to temper rampant inflation. On June 15th, the Fed surprised the market by raising interest rates by 75bps instead of the expected 50bps. Markets are in the red as investors consider the longer-term economic impacts of rising interest rates. There is no more “buy the dip”, and there is no longer a certainty that the Fed will rescue equity markets as it has in every other downturn since the 2008 Global Financial Crisis. In the recent past, investors have remained confident that the Fed would either lower interest rates or pause plans to raise if stocks declined too much. There is no such confidence now as Fed Chairman Powell is determined to keep raising rates until inflation is tamed. This is the right strategy.  In our view, the Fed is “letting the air out of the tires” to keep our economy from skidding off the runway.  

Many investors are still hopeful that the Fed can engineer a soft landing. I don’t believe that outcome is likely, nor do I believe it to be the right focus.  As noted by former U.S. Treasury Secretary Larry Summers, anytime we have had unemployment below 4% (currently 3.6%) and inflation above 4% (currently 8.6%), a recession always follows within 2 years. There is an air of inevitability that a recession is pending. When inflation is significant, so is the following downturn. For overheated markets, overcooling is eventually required.

A slowdown in the economy (and stock market decline) is part of the Fed’s plan as it is a backdoor method of reducing consumer’s incomes and spending via the “wealth effect”[1]. When investment portfolios are down 25%, consumers begin to reconsider discretionary and luxury purchases. What we are beginning to see now – fall­ing share prices, asset prices, mortgage applications, and housing demand are all help­ful to the Fed as long as markets don’t fall too much and damage the real economy. Falling markets make peo­ple feel poorer, en­cour­ag­ing them to save more and spend less.

Another “positive” sign that we are heading in the right direction is rising unemployment. The only scenario in which inflation will drop from 8.6% to the targeted 2% range is if unemployment is higher. When there are too many jobs (more job openings than people to fill them), consumers feel confident about job hopping and asking for more money. No one is hoping for higher unemployment, a 2% rise in unemployment would mean job losses for 3 million Americans. But it is a sobering requirement for us to cure our current ailment.  As more people become unemployed or there are fewer jobs available (job market tightening), consumers focus on saving for a rainy day. When we all save (vs. spend) and refuse to pay prices That. Just. Seem. To. Keep. Rising. inflation eases and prices stabilize.  

The Fed is taking the right steps, and we are actually entering the recession on strong footing. 

The one topic which, in my view, is not covered enough is the concept of “deglobalization”. Deglobalization is the process by which countries around the world begin to depend on each other less, and trade and investment between partner countries begins to decline. A key measure of globalization — trade’s share of global GDP — peaked in 2008 at the start of the Great Recession.

For the past 40+ years, globalization has been a strong counterbalance to inflation. Global trade increased competition and added hundreds of millions of low-paid employees to the global workforce. It increased the efficiency of product development through market specialization – portions of the manufacturing process for goods could be outsourced to countries most specialized to deliver in the most cost-effective manner. Those goods could then be delivered through a highly efficient global supply chain. Interdependence kept a lid on prices for goods. Interdependence brought the world’s best minds together to address pressing global problems such as energy, disease, famine, and climate change. In recent years, this behavior has changed. A geopolitical cold war with both China and Russia created protectionist pressures (Tariffs and a Trade War) while the self-interested behavior during the Covid-19 pandemic made global leaders question the wisdom of relying on other countries for key goods and services. And of course, the pandemic itself made cross border traffic more challenging. Countries are now more concerned with closing their borders to immigrants lest they take the jobs of more deserving natives. And, as the war in Ukraine drags on, and multi-national companies withdraw permanently from Russia, leaders wonder whether future conflicts will impact their ability to reliably source supplies. Each of these obstacles have led to more nationalistic behavior globally.  When countries can’t (and don’t) rely on specialization from partner countries better positioned for those functions, costs …and prices …rise.

The hope is that the globalization phenomenon has merely peaked and isn’t heading towards a permanent retreat. A perfectly commingled world is an impossibility. But we are much better off when can leverage the strengths and specialization of partners to increase our output at home.  The implications are that this silent factor could cause inflation to linger despite the Fed’s best efforts.  


1 comment

  1. Thanks for the write-up. Yesterday 10Y1Y yield curved just inverted together with 10Y2Y. Knowing the likelihood of recession, what is your plan in managing your portfolio?
    ready to sell all, partial, re-allocate, hold or buy? Thanks.

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