The third quarter of 2022 finally came to an end as the market continued to deteriorate for most of this calendar year. In September alone, the market gave up roughly 9% of its value. This year, the Dow Jones Industrial Average is down 21%, the S&P 500 is down 25% and finally the hardest hit, the tech-heavy NASDAQ is down 32%. The central issue on the year-long sell-off, is of course inflation. Typically, inflation is caused by rising energy or commodity prices like we experienced during the 1970’s, with the Organization of Petroleum Exporting Countries (OPEC) induced energy crisis. Or, among developing countries whose very loose monetary controls often produce startlingly high inflation rates — sometimes as high as 80%. But, here in the US, we have maintained a low inflation rate of about 2% since the 1980’s. However, now we are dealing with the aftermath of the economic consequences of a global pandemic and the disruption imposed by mandatory shutdowns of many sectors of the economy. Clearly, the environment produced by these factors is unique in history. It should be remembered that in the fog of war everyone tries to make the best decisions possible with limited information. With 20/20 hindsight, we can see where both good and bad decisions were made.
The Federal Reserve Board (The Fed) has one primary objective — to control inflation. In general, they have done a good job of keeping inflation at about the 2% annual target. Historically, the Fed has been poor at predicting inflation; the latest case in point is that initially during the pandemic shutdowns, the Fed clearly expressed their conviction that inflation was in their words, “transitory” or temporary in plain English. The Fed thought inflation was temporary and primarily due to supply-chain disruptions. This miscalculation caused the Fed to aggressively lower interest rates to zero and inject money into the economy through quantitative easing (QE). Further exacerbating the inflation problem was Congress and two Presidential Administrations passing three pieces of legislation that also injected trillions of dollars to the economy. Between the Fed and Congress, more than $6 trillion was injected into the economy in a very short period of time. To give a little perspective to just how much money this is, if one second equals one dollar, it would take 32,709 years to equal one trillion. Remember, it was $6 trillion that was added to the economy, with essentially zero interest rates. This money did help many who were victims of COVID and the related shutdowns, but eventually the money migrated from the low-income recipients to other sectors of the economy and created a disincentive to return to work. Zero interest rates and a likely permanent change to remote work propelled the housing market to new record levels.
The stock market along with the rest of the economy was swept along in this environment as well. After initially plummeting in March 2020 on the news of the shutdowns, it quickly recovered as trillions flowed into investments. Throughout the last half of 2020 and all of 2021, the market moved from one record to another as it anticipated the economic recovery that was unfolding. Technology stocks that were well suited for the new work at home environment did the best. That environment began to change toward the end of 2021 and into the beginning of this year. It became apparent that inflation was here to stay. It was especially felt at the gas pumps and grocery stores. Everyone felt the pain, and while a little better now, high prices for most things persist with an inflation rate currently at headline CPI of 8.3% and core CPI at 6.3%. Worker shortages were widespread across the country, as it was financially more advantageous to stay home than return to the workplace. Consequently, wage inflation moved higher, although not as fast as goods and commodity prices.
The most potent weapon in the Federal Reserve’s arsenal in controlling inflation is increasing interest rates. So far in 2022 the Fed has raised interest rates by 0.25% in March, 0.50% in May, 0.75% in June, 0.75% in July, and 0.75% in September. This is the most aggressive the Fed has been in recent history, going to battle with the most aggressive inflation we have had in recent history. Increasing interest rates to stop inflation is a little like treating cancer with chemotherapy. In many cases, chemotherapy can shrink or eradicate the disease, but at a great price paid by the rest of the body. So too, increasing interest rates can kill inflation, yet take a tremendous toll on the economy. So, while inflation is addressed, we will likely enter a mild but felt recession in the coming months. In large part, the sharp sell-off in the stock market this year, and especially in September is anticipating this likelihood of recession. Already, we have seen the residential real estate market begin to plummet. Lumber prices last year skyrocketed briefly but have already fallen below pre-pandemic levels. Wage inflation will likely be the stickiest type of inflation, but we are already seeing large scale layoffs in the tech sector or reduction in hiring. What could potentially worsen the human cost in a recession is that savings rates have dropped to 2009 levels and debt is increasing rapidly to 2011 levels. In short, a recession is like experiencing short-term pain for long-term gains.
There are a variety of other factors that could prove disruptive in Q4. The escalation of the war in Ukraine, perhaps Russia using tactical nuclear weapons or sabotage of the Nord Stream pipeline. Europe is appropriately worried about the coming winter with little fuel for heating. The U.S. mid-term elections could shift the balance of power in Congress. The devastation in Florida primarily, but also in South and North Carolina from hurricane Ian, could take a financial toll. However, the long-term recovery from other devastating storms has proven to be very positive for such areas. It’s important to remember that no price can be placed on the human toll in such disasters.
Let me conclude with a potentially positive look at what otherwise is a gloomy economic climate. First, by many internal measures the stock market has fallen too sharply or is oversold. The selling has been relentless for most of the year with only a very brief rally or two that each time was quickly overwhelmed by selling. Second, the Federal Reserve’s tough talk by Chairman Powell and other Fed Governors in September, combined with a 0.75% rate hike, spooked the market and intensified selling, with the fear of a recession soon. Because the market looks six-to-nine months in the future, any hint that such a recession might be shorter and shallower than expected, could prompt a rally long before the good times arrive for the general public. Third, currently the Executive and Legislative branches of government are controlled by one political party. There is a strong probability that the Legislative branch could be controlled by the opposing party, hence creating a “divided government.” Historically, the markets do better when a divided government is in place because the government is less empowered to interfere with the free-flowing nature of the American economy. Lastly, the U.S. maintains clear global superiority when it comes to the most important areas of technology and medicine. These two industries in particular are beginning to aggressively re-shore foreign operations back to American soil, creating safer and better security as well as a plentiful source of new jobs.
Many studies over the last several decades have proven that the lion’s share of stock market recoveries take place suddenly and with significant single-day gains. Essentially, this means it’s nearly impossible for anyone to pick the exact bottom or top of a market cycle. Proper diversification of risk can be addressed to weather the downsides of the market without missing the inevitable recoveries that quickly develop. If the market begins to look beyond the current gloom, a well-diversified portfolio will respond nicely when and if the market moves back to rally mode.
The commentary and market insights provided by John Slavic are for informational purposes only and do not guarantee future results.