We currently find ourselves in an economic environment not seen in nearly 40 years. Not since the late 1970s and early 1980s have we seen inflation this high and interest rates increasing at this rate. The last 2+ years have been some of the most volatile in the history of American financial markets. At the start of 2022, the S&P 500 was up over 100% since the pandemic low, the fastest doubling ever. The movement in some technology stocks was especially insane: many fell 50-60% during the Corona Crash, went up 4-5x, only to drop 70-90% from those highs all in a matter of 18 months in some cases.
As unprecedented as all that was, it has been the bond market this year that has really posted some of its largest losses ever. So far, the Bloomberg Aggregate Bond Index is down just over 10% this year. That would be by far the worst year since interest rates started their decline in the early 1980s. Interest rates and bond prices have an inverse relationship. Because interest rates are increasing at such a brisk pace, bonds are getting clobbered. This has presented major problems for the classic 60/40 portfolio, with bonds unable to provide any cushion to declining stock prices this time around.
For almost a decade or more, investors have been predicting this bond/stock dilemma. That’s because of just how low-interest rates had gotten. They knew that if inflation were to rear its ugly head, our current circumstance could easily materialize. So why is inflation here anyway? Why are prices of all goods and services up so much over the past year? I think you can blame inflation on three things. First, is the fact that the monetary and fiscal stimulus provided during the pandemic was, in hindsight, overkill. The American Rescue Plan Act of 2021 was signed into law on March 11 that year and provided $1.9 trillion in government spending. The unemployment rate sat at 6% that month and would fall to 4.5% by the end of the summer. The economy was already in full recovery mode, but it was hard to know what the future held at that time.
Second, supply chains that were destabilized by Covid-19 have contributed to the rise in prices. This, too, has been improving, but if we are entering into a world of “deglobalization,” this trend may never fully return to what it once was. Thirdly, the war in Ukraine was the proverbial gasoline (no pun intended) on the fire. Russia accounts for 10% of oil and gas exports globally, and a far greater percentage to Europe. Together the two countries also account for 25% of wheat exports around the world, and Russia is also a major supplier of fertilizer and industrial metals like aluminum.
For the remainder of the year nothing matters to markets more than the monthly Consumer Price Index report, also referred to as “headline inflation.” If that increase persists, you can expect the Federal Reserve to keep increasing interest rates, which in turn will continue to put pressure on the prices of assets from stocks to bonds to real estate.
As bad as things seem right now, it is important to remember just how good they have been for the last 10 years. The US stock market is up 280% over the last 10 years, 13% on an annualized basis. And, as always, everything in finance and economics is relative. When you compare the situation in the US with that of Europe things look quite different. For example, at the end of June this year gasoline prices in Europe were as high as $8.66 per gallon. The differences in price for liquified natural gas (LNG) are also noteworthy: due to the war in Ukraine, and the economic battle between Russia and the West, prices for LNG in Europe are triple, even quadruple the price in the US in some cases. Germany is now talking about rationing gas this coming winter. Importing LNG from other countries like the US is not a great option due to the high cost of shipping the commodity. (Did you know LNG must be kept at a temperature of negative 240 degrees to ship across the ocean?!) From an energy standpoint, the US is in far better shape than Europe. This is helped by the fact the US is one of the largest oil & gas producers in the world.
Despite its volatile financial markets and political discourse, the US is still the best game in town when it comes to equity markets. Capital must go somewhere, and it is my belief that that somewhere will continue to be the US for time being. Inflation too will subside, eventually. We have seen some positive signs of that recently: commodity prices have started to come down and big retailers are reporting massive amounts of inventory. While a recession in the near future is a very real possibility, it’s far better than a wage/price spiral where inflation gets out of control. It’s times like these that I often use a quote from one of the best books on finance in recent years, The Psychology of Money by Morgan Housel:
Like everything else worthwhile, successful investing demands a price. But its currency is not dollars and cents. It’s volatility, fear, doubt, and uncertainty - all of which are easily overlooked until you are dealing with them in real-time. Market returns are never free and never will be. They demand you pay a price like any other product. The trick is convincing yourself that the market's fee is worth it. That's the only way to properly deal with volatility - not just putting up with it but realizing that it's an admission fee worth paying.