In addition to springing forward an hour for daylight saving time, it seems like the clock has also recently been turned all the way back to the 1970s in some unfortunate ways. Rampant inflation, an oil supply shock, and Russian military expansionism have all once again reared their ugly heads, injecting significant volatility into global markets and leading to the first correction in the S&P 500 since the early days of the pandemic.
Even before Russia’s invasion of Ukraine, inflation had already reached multi-decade highs. A collision between robust demand and persistent supply shortages has been the primary culprit of the spike in prices. Demand has been boosted by a strong labor market and trillions of dollars in government stimulus. At the same time, many suppliers have been unable to operate at full capacity due to Covid-related disruptions as well as worker shortages resulting from a voluntary withdrawal from the labor force by a number of people since the start of the pandemic. The worker shortages have also led to a spike in wages, which has further fueled inflation. Federal Reserve officials (and many private-sector economists) were caught off guard by how persistent and pervasive inflation has become, believing for much of last year that prices would quickly normalize on their own as the supply-chain disruptions dissipated. It was not until late last year that the Fed recognized that strong demand and a quickly tightening labor market were also major contributors to inflation that would need to be addressed.
While the Fed still expects the supply-chain strains to ease this year, it now recognizes that this in itself will not be enough to bring inflation down to an acceptable level and that it must take action to reduce demand and economic growth by raising interest rates. It began this process a few weeks ago by increasing its benchmark overnight lending rate by a quarter percentage point to a range between .25% and .5%. It also plans to continue with a consistent series of hikes over the next couple of years that it currently expects will result in a terminal rate of about 2.9%, which would represent the highest level since 2008. Anticipating the series of Fed hikes to come, longer-term bond yields have risen sharply this year, with the yield on the 10-year U.S. Treasury note up nearly a full percentage point to 2.3%. While yields have so far just returned back to levels seen in 2019 before the Fed implemented its ultra-loose monetary policy in response to the pandemic, the increase has nevertheless weighed on stocks, as rising yields are wont to do. How high and fast the Fed ultimately ends up raising rates and bond yields end up climbing depends largely on the path of inflation, which is still very much uncertain at this time. A faster series of rate hikes would increase the likelihood of a sharper slowdown in economic activity and higher financial market volatility. The economy is entering the rate-hiking cycle on solid footing, with a strong labor market serving as its foundation. Even so, the Fed’s task of raising rates high enough to tame inflation but not so high as to tip the economy into a recession is a difficult one, as evidenced by its very mixed historical track record of engineering such so-called soft landings for the economy.
The Fed’s already delicate balancing act has been made even more difficult by the war in Ukraine. In addition to the tragic humanitarian toll inflicted upon Ukraine, the war has also exacerbated inflation. The war and the escalating sanctions imposed on Russia by the West have further disrupted supply chains and caused a surge in prices for a whole range of important commodities that Russia and Ukraine produce in abundance, including oil, natural gas, and many key metals and grains. An extended period of elevated prices for these commodities would increase the chances of sustained inflation and reduce the chances that the Fed will be able to successfully tame it without causing a recession.
The market hates uncertainty, and it currently has it in spades. As a result, market volatility is likely to remain elevated until there is greater clarity on the war in Ukraine, the path of inflation and interest rates, and how resilient the economy will remain. What is certain is that the economic environment is different now than it has been in quite some time, with inflation having taken root and the Fed about to embark on a significant rate-hiking cycle. Since our founding in 1956, we have helped guide clients through a number of different economic and market cycles and remain convinced that owning a diversified portfolio of financially strong companies with solid earnings and healthy free cash flow is the best way to weather market volatility and achieve long-term financial goals. We expect the additional volatility to produce opportunities to buy quality companies at a discount to their intrinsic value, and we are prepared to take advantage of such opportunities as they arise.