The Impact of Inflation on the US Markets

The Impact of Inflation on the US Markets

Dear friends,
We hope you’re enjoying a pleasant summer with friends and family.
As we enter the third quarter of 2022, we are reminded of Lenin’s words on the Russian Revolution: “there are decades when nothing happens, and weeks when decades happen”. Events in the last three months have certainly fit into the latter category.
Earlier this year, the Russian invasion of Ukraine led to remarkable actions by financial and commercial institutions allied with the EU and US. As the war has dragged on, it is increasingly clear that the EU and US will not directly engage Russian forces, which reduces the immediate risk of this war drawing in many other actors. The tragic reality for Ukraine is that it is likely facing a loss of territory which will impact about half its population. The longer term lesson that all small/mid-sized countries will likely learn from this is that the only true deterrent for larger hostile nations is independent nuclear weapons capability. The treaty obligations made by Russia when Ukraine dissolved its nuclear weapons program in the 1990s aren’t worth the paper they were written on. The assurances made by the EU and US to Russia on the cusp of the breakup of the Soviet Union have been broken in both spirit and word.
In terms of impact to global markets, for now they appear primarily limited to the energy sector which has seen further supply issues. Equity investors exposed to Russia are directly impacted, but given Russia’s limited output and energy concentration, the short term direct impact remains minimal. Commodity prices have also been impacted, most notably oil/natural gas and wheat (Ukraine produces approximately 10% of the world’s wheat). This in turn has put additional short term pressure on inflation.
US financial markets have much broader issues to absorb and deal with. The weeks before the official start of summer saw every major US stock market index slip into bear market territory (defined as a 20% drawdown from the index highs). This was presaged by sharp, steep declines in the most speculative assets such as crypto-currencies and related tech. The onset of summer and a seasonal drop in trading has temporarily halted the declines, but the underlying causes have not disappeared and we suspect markets will continue to experience sharp volatility in the coming months.
We now have several months worth of inflation figures at levels we have not seen for decades. The Federal Reserve has telegraphed its intent to raise interest rates until inflation is under control. Their target rate for inflation is 2%, while inflation currently stands at approximately 9%. The risk of increasing rates too quickly is that it could drive the economy into recession. However, given where unemployment levels are (still historically low), it appears the Fed is more concerned with runaway inflation than recession risk. The thinking being they can always reverse course with rates once inflation is more manageable. Industries most sensitive to interest rates (mortgage origination and speculative new home construction among them) are experiencing sharp declines in revenue and canceled orders. In financial markets, speculators and corporate insiders who
have borrowed against stock, find themselves exposed as prices fall and the cost of carrying margin debt rises. This is a vicious circle that can lead to rounds of forced selling.
Since inflation concerns are driving the Fed’s aggressive policy moves, if inflation slows meaningfully, we could see the Fed pause to take stock. In this scenario, we would likely see both stocks and bonds rally (though this may be a shorter term relief rally). Intermediate and long term bonds are pointing towards such a pause in rate hikes. The closely watched 10-year treasury is back under 3% after nearly touching 3.5% in June. This suggests bond investors don’t expect interest rates to remain elevated long term.
This bear market comes at the end of a nearly 40 year long secular decline in interest rates and sustained low inflation. These trends were coincident with very large labor pools in Asia being integrated into the global economy. The deflationary impact of adding hundreds of millions of workers across Asia to the global industrial and services labor market seems to have run its course. Anecdotally, we are seeing salaries for remote service workers approaching rough global parity. This is likely to mean better conditions and more bargaining power for workers in the long run. In the short term though, the inflationary pressures will likely mean higher labor market volatility, including elevated unemployment. Similarly, an improvement in labor conditions and wages will lead to more sustainable and better quality corporate earnings. In the short term, it means increased market volatility.
Corporate earnings remain at cyclical and all-time highs for large capitalization stocks. Despite the recent declines, price/earnings ratios are not yet close to past cyclical lows. When we look around for signs of a bottom, they are scarce and distant. Our expectation is that the markets will remain volatile and further declines remain likely. We continue to advocate for defensive portfolios incorporating high quality stocks, short term/floating rate/inflation protected bonds, commodities and precious metals.
On the other side of this bear market lies another bull market and we will continue to keep an eye out for investment opportunities as they appear.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

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