Where Do We Stand?
As most know, the market has had its worst beginning of the year since the 1970's and has entered the second bear market within a 2-year period. Starting in 2021 among the smaller companies, this bear market has – this year – moved into the largest and most recognized companies.
Here are just a few examples with their year to date returns:
JP Morgan -30%
DR Horton -34%
Source: TC2000 Charting Software
The markets themselves are down almost 23% for the S&P 500 and closer to negative 33% for the Nasdaq 100. Even the BND (an ETF representing the returns for investment grade US debt) is down 10% this year .
There are several reasons for these markets, but here I will focus on inflation.
When the pandemic began, we hit the panic button somewhat and – between the Fed providing quantitative easing, lower rates and congress pushing higher stimulus– we spiked the M2 money supply dramatically (by almost 30%).
Now spiking the money supply might not be a bad thing, but we did so going into an environment of LOWER productivity. In essence we asked people to stay home and, many, not to work. We furloughed service workers, physical laborers, office workers, and even doctors who performed elective surgeries. This was easily seen in the GDP as it declined roughly 10% in the 6 months from Q4 2019 to Q2 2020 . To put it simply, people had money to BUY stuff, but nobody was BUILDING stuff. Too much money chasing too few goods and there it is – inflation.
To note inflation as “transitory” was monumentally stupid on Jay Powell’s part (and he was not alone among economists). It gave the impression that we could turn the economy on and off like a light switch. Of course, this can’t happen because the economy is not a “thing” like a black box. It’s a complex interconnected structure with multiple inflection points (like an organism). Much of our current economic situation has been attributed to “supply chain disruption” but it’s also labor dislocation, messy tariff arrangements, just in time inventory structures, no backup capabilities, among a large body of other factors. Some may remember the phrase ‘ceteris paribus’ (all else equal) from their days in economics class. The phrase was usually involved in a discussion around what would happen if we changed one thing and assumed that nothing else changed. Maybe not the most realistic way of viewing the economy. Similarly, the word “Transitory” speaks to a perception among the Fed and economists that making changes to the economy is like removing one piece from a Jenga tower. In reality, it’s more like throwing an entire Jenga tower into the air and hoping it will land back in its place as it was before.
That said the process is beginning to heal. Sure, the Fed has begun a blunt force approach to raise interest rates and lower demand, but companies have also begun to diligently work on supply chain issues and are beginning to gain ground.
If you are looking for this to show up right away in economic indicators like the PCE deflator, don’t. It will take a couple more readings. But if you want to know that it is happening, looking at commodity prices might provide a clue.
Here are a few commodity charts:
As demand slows prices will follow. This does not mean that inflation is completely gone but it does indicate that prices are softening. The next indicator we should look for is wage inflation, rate of hiring, and rate of firing. While unemployment is still low, continued lower economic activity will result in layoffs and wage pressures to the downside. This has already – albeit quietly – begun to happen and will be more noticeable in the late summer and early fall. And while lower inflation is what we want, it comes with lower economic activity which is what we don’t want. We will touch on the implications of this in coming pieces, stay tuned.
Sources 1. TC2000 Charting Software. 2. https://www.bea.gov/data/gdp/gross-domestic-product