Wealth Matters Newsletter - April 2022

A quote attributable to Samuel Clemens (a.k.a. Mark Twain) might be fitting to describe the events and market conditions that unfolded during the first quarter.  It’s difficult not to sound hyperbolic when we say investors and policy makers were faced with a generational confluence of events, the likes of which have not been witnessed in decades.  Considering we have had a war develop in mainland Europe, 30-year-high levels of inflation, commodities price/supply shocks, and continued supply chain disruption, it should be no wonder that most capital markets have pulled back from the highs we saw in early January.  Where do we go from here?  Let’s first consider historical events similar in scope to those we face today.

Inflation

The chart below depicts a history of the Consumer Price Index (CPI) and core CPI (excludes food and energy).  There have been many comparisons to the inflationary environment of the 1970s and early 1980s in recent months; there are some similarities in economic conditions.

Inflation experienced in the 1970s was driven by significant government spending on the Vietnam War effort, which compounded demand imbalances rooted in expansionary policies from the 1960s.  Add in the removal of the gold standard for the U.S. dollar, an oil embargo, and a Federal Reserve hesitant to raise interest rates for fear of pushing the economy back into a recession, and we see the resulting peak in CPI in 1980.  Fed Chair Paul Volcker pushed the Fed Funds rate to near 20% in early 1980 to curb inflation, causing the recessions depicted on the chart.  

The current inflationary environment has its roots in massive government spending programs (increase in money supply) and easy monetary policy stemming from the pandemic, and supply shocks as supply chains remain disrupted from the pandemic.  U.S. consumer spending for goods contributed to the supply chain issues, as the opportunities for service-related spending (restaurants and vacations) were diminished during the pandemic.  More recently, sanctions on Russia have added to already elevated food and energy prices due to Russia’s and Ukraine’s global supply of energy and agricultural products.  Given the unknown duration of the war in Ukraine, it is safe to assume food and energy prices will be challenging for some time.

The Fed announced a 0.25% (25 basis point) increase in the Fed Funds rate at its March meeting, a move widely anticipated by investors.  Prior to Russia’s invasion of Ukraine, investors were anticipating a 0.50% increase.  It is clear that the Fed is behind the curve in fighting inflation, believing that the inflation spurred by the pandemic would be transitory.  It is likely that the Fed will raise interest rates at every one of its Federal Open Market Committee meetings this year and current estimates indicated one or more 0.50% increases. Markets are already reflecting this sentiment; interest rates have moved up precipitously in recent months.

The challenge now for the Fed is to raise interest rates sufficiently to tame inflation without triggering the next recession.  In the past, this has proven to be problematic, as tightening monetary policy has historically led to slower economic growth, if not outright recession. According to a report published by Piper Sandler on March 25, 2022, the Federal Reserve has raised interest rates nine times since 1961 to combat inflation and a recession followed eight of those tightening regimes.  We have already begun to feel the impact of higher interest rates.  According to Bankrate, the national average 30-year fixed mortgage rate was 4.89% on March 31, 2022; mortgage refinancing activity fell 15% from the previous week and 60% from the prior year according to a recent report from the Mortgage Bankers Association.  How high will mortgage rates need to move before the housing market starts to cool?  As we enter the spring selling season, investors will be watching activity closely, as housing has been a substantial contributor to consumer wealth over the last several years. 

Geopolitical Conflict and War

As of this writing, the war in Ukraine is well over one month in duration.  The immediate impact of Russia’s aggression is sizeable, considering the humanitarian crisis and economic effects of overwhelming international sanctions.  The future impacts of these events are much more difficult to estimate; energy and agricultural commodities provided by Russia and Ukraine are meaningful to the global economy and will not be easily or quickly replaced.  Millions of Ukrainian refugees are displaced and the scale of infrastructure devastation likely approximates what was witnessed in parts of Europe during World War II.  It can be difficult to look past the images and impact of these events and rationalize a positive outlook.  Yet, if history can be a guide, consider the following chart from Vanguard depicting stock market actions after geopolitical events. 

Investors dislike uncertainty, which is the primary cause of market volatility after events such as these; we often refer to this as “event risk.”  So why have markets rebounded in the past, as the examples above depict?  We think a primary reason is because the event itself is no longer an unknown.  The markets are forecasting mechanisms, so investors begin to look beyond the events themselves and consider potential outcomes.  As noted earlier, the duration and impact of these still unfolding events are difficult to assess, but it would not be surprising if markets moved beyond these events in time.

Generationally high inflation and a war involving a nuclear power have unsettled investors and policy makers alike.  The path to resolution on each matter will continue to present challenges to the global economy, policy makers, investors, and the individuals impacted most by the confluence of these events.  As we have borne witness to similar events in the past, the lessons learned may come to bear once again, but as investors, it is important to remain focused on the long-term and maintain a diversified portfolio.  Whether or not history repeats or rhymes, patient investors have been rewarded.