Threading the Needle

The S&P 500 barely managed a gain during the third quarter, which featured an uptick in volatility driven by growing inflation concerns, the U.S. debt ceiling debate, and negative headlines out of China.  Notably, the S&P 500 ended a streak of 227 days since its last 5% decline, the 7th longest such streak on record.  Most other asset classes – from small cap U.S. stocks to international stocks to investment grade bonds – all closed negative.

While the debt ceiling debate and Chinese turmoil are causing some anxiety, the prospect for sustained inflation is the largest driver of investor unease right now.  Rising inflation can lead to higher interest rates, which could put a crimp in both stocks and bonds.  Last quarter, with stocks hitting record highs, we indicated that there were two key questions moving forward:  1) Can the economy maintain its breakneck pace of growth?  2) Will inflation rear its ugly head?

Early indications are that economic growth is slowing, at least in the shorter-term, and inflationary pressures are building – potentially, for the longer-term.  Average real GDP forecasts have been revised down recently, while inflation is running at the fastest pace in three decades.

Given the rapid “V-shaped” recovery over the past year and a half, the slowing economic growth is unsurprising.  The economy responded to its largest ever contraction during the second quarter of 2020 with an equally impressive bounce back.  Maintaining that rate of growth would have been a monumental feat.  The economy is still growing, just not at the previous breakneck pace.  The bigger concern is inflation, with the prices of goods and services increasing, housing costs soaring, and wage growth accelerating.

How Did We Get Here?

Consumers emerged from the Covid-induced economic shutdown ready to “get back to normal” and primed to spend.  A combination of extra savings (the result of not going to restaurants, taking vacations, etc., while locked down) and plentiful government stimulus meant that many consumers were sitting on extra cash.  As the economy began to reopen, consumers unleashed a wave of pent-up demand that companies were unprepared to meet. 

During the shutdown, many companies were forced to take factories offline and reduce employee headcount.  This was compounded by a shortage of raw materials and employees simply quitting or retiring in the face of the pandemic.  Once the economy reopened, consumer demand returned so swiftly that businesses simply couldn’t keep up.  Remember, businesses don’t operate in a vacuum.  Most rely on other companies to help provide their goods and services.  There is a cascading effect where if a supplier is unable to provide a critical input to a business, then that business may be unable to supply their customers… and so on.  The gears of commerce must all be in sync for an economy to function efficiently.  If one gear gets stuck, the machine can grind to a halt.

The stories are now everywhere:  furniture and appliances on months-long back order (if available at all), home renovation projects delayed or quoted at astronomical prices, local restaurants desperate for wait staff, empty shelves at grocery and discount stores, airlines unable to run normally scheduled routes, and the list goes on.

While companies are still doing well financially – many more profitable than ever before – they simply cannot meet consumer demand.  There’s too much money chasing too few goods and services, the classic definition of inflation.  And to reiterate, it’s not only consumer demand driving inflationary pressures.  Rising material costs, supply chain disruptions, and labor shortages are forcing companies to hike prices, which they attempt to pass along to consumers.  The problem is, at some point, consumers become less willing to pay those higher prices.  Therein lies the rub for the economy and financial markets.

While some inflation should be expected in a healthy economy – which is why the Federal Reserve targets 2% annual inflation – too much inflation can be a negative.  If consumers start balking at higher price tags on goods and services, they’ll stop buying.  Corporate earnings will be negatively impacted.  A reduction in corporate earnings could lead to layoffs, less business spending, and reduced investment – all negatives for the economy.  Which brings us to the aforementioned Fed.

Threading the Needle

It has become cliché at this point, but all eyes are on the Fed.  They have what is called a “dual mandate” in order to achieve economic stability.  They aim to 1) promote maximum employment (in other words, they want to lower the unemployment rate) and 2) promote stable prices and moderate long-term interest rates (they want to keep inflation under control).  Following the global financial crisis in 2008 and again with last year’s Covid crisis, the Fed quickly went to work pursuing their mandate by lowing interest rates and buying financial assets.  Even though the economy has since recovered from last year’s second quarter nosedive, the Fed has continued holding rates low and buying $120 billion in Treasury bonds and mortgage-backed securities each month.  Combined with government stimulus, the end result is an abundance of liquidity in the financial system.  This can further fuel price increases by supporting the “too much cash” side of the equation in the classic inflation definition mentioned earlier.

From a financial market perspective, low interest rates and lots of cash sloshing around the system has been a boon for stocks, bonds, and other risk assets.  The money has to find a home somewhere.  Low rates have forced additional risk-taking by investors seeking returns.  Ultimately, this can spur asset bubbles, which tend to end poorly and are something the Fed would rather prevent.

On the other hand, if the Fed tapers bond purchases and/or hikes interest rates prematurely, they could inadvertently throw a wrench into the economy which might not be fully ready to stand on its own.  Higher rates impact everything from mortgages to auto loans to credit cards.  From an investment perspective, rising rates can negatively impact bond prices, which tend to move in the opposite direction of rates.  Stock prices may also take a hit as investors discount future corporate earnings at a higher rate.  This is particularly impactful for longer duration growth stocks, with anticipated earnings much further out into the future.  Higher yielding bonds could also siphon demand away from stocks as investors look to shed riskier assets in favor of more stable returns.

The Fed is obviously aware of their dilemma and has been closely monitoring whether inflation appears transitory or something more sinister.  Expectations are they will begin “tapering” this quarter, reducing their bond-buying program which has helped to stimulate the economic recovery.  However, past attempts by the Fed to take a more hawkish approach – most recently in the fourth quarter of 2018 – were not well received by the financial markets.  The Fed will have to thread the needle, attempting to keep inflation in check without bringing the economy to its knees.  They also must contend with wild cards such as the Delta variant and fiscal policy out of Washington D.C.

So What Does This Mean for Investors?

While this quarter’s commentary may feel less than optimistic, we don’t view it that way.  The Fed has skillfully navigated two major crises and has given no indication they’ll misstep when dealing with the current inflation dilemma.  That said, we believe it’s prudent for investors to prepare for further volatility.  It’s entirely plausible that inflation is kept in check, economic growth remains healthy, and financial assets hold steady.  However, it’s also possible that the economy overheats, interest rates rise more rapidly than expected, and stocks and bonds come under pressure.  There’s also a third scenario with low or no economic growth and high inflation, otherwise known as stagflation.

As always, diversification guides our portfolio considerations.  We strategically own assets that perform differently in various market environments.  If the Fed fails to thread the needle, diversification should provide a necessary counterbalance.