Since the Global Financial Crisis, we have operated in an environment where money has been “cheap”. When the Federal Reserve lowered the funds rate to a range of 0 to 0.25% during the heart of the pandemic, some might have even described money as “free”. Established companies could raise debt at historically low rates for any number of projects. Young startups could access venture capital to fund their operations as they searched for a path to profitability. And private equity firms had capital to lever up their portfolio companies to boost returns and de-risk their investments. Lower interest rates and over $14T in fiscal and monetary stimulus worked together to stimulate the economy. With interest rates approaching near zero, governments, businesses, and consumers had ready access to money whenever they needed.
The US economy is still running hot. The third quarter brought more of the same volatility seen throughout the year. The markets are adapting to The Fed’s medicine: higher interest rates to slow the economy. On September 21st, The Federal Reserve bank increased the federal funds rate by another 75bps. This was widely anticipated. However, in his comments, Fed Chairman Powell emphasized that their number one focus is fighting inflation. Until this point, markets had been reluctant to take him at his word with many expecting that he might soon pause or reverse. Now, the message is clear, the Fed will do “whatever it takes” to beat inflation.
“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.
“Most of the time, the end of the world does not happen. “ — Howard Marks, Co-Founder of Oaktree Capital Management
As we close the first quarter of 2022, all signs point to our economy moving into a new stage of the business cycle. We are past the peak and rolling into the earliest stages of contraction. After laying the groundwork for months, the Federal Reserve Bank officially began raising interest rates earlier this year. Their goal is to dampen inflation which has now increased to alarming levels and is affecting businesses and families across the socioeconomic spectrum. The Fed has most likely taken too long to act, and they are removing stimulus that was too excessive and lasted for too long. While the Fed’s quick action likely saved our economy from the worst possible outcomes during the pandemic, we are now surrounded by inflation that is having real world impact.
Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. -Sam Ewing (author)
We ended 2021 similar to how we began, challenged by Covid as the virus continues to alter holiday plans, disrupt commerce and frustrate a world weary of the conversation. Covid was supposed to be conquered by this point, but virus mutations and vaccine hesitancy have allowed this visitor to remain with us. What is different this time around is the Omicron variant appears to be more prevalent, but less deadly. Hospitalization risk appears to be 1/3 that of the Delta variant but, given that Omicron is more infectious and has a shorter incubation period, hospitalizations are going up. We began 2022 with an all-time high of 1 million active new U.S. cases.
The S&P 500 is up 14.4% for the first half of 2021. Much of these gains were triggered by companies announcing positive earnings expectations for the second half of the year. A record 64% of companies that provided guidance exceeded Wall Street Analyst projections. Most companies have positioned the pandemic in the rear-view mirror and expect things to get better from here. Meanwhile, the Market continues to hit all-time highs, while Wall Street seems to be overly conservative on future prospects. The source of caution stems from expected inflation.