In the Thick of It

Boom, Bust. Crash down, Crash up. It’s back to that. The best day for the Dow in 2022 was followed by the worst this week. And that overtook last Friday’s sell-off, which was then the worst. These 1,000 point Dow moves can be gut-wrenching and stressful. We live in an age of extremes. We just need to maintain our discipline and fight through it. We’re doing it.

Things are murky right now. We are in the thick of it. The Chairman of the Federal Reserve tried to clarify things. His calming attempt worked for 20 hours. It stopped working after that. Sinking markets usually lead to rate cuts not hikes. Not this time, inflation is at multi-decade highs. There’s a war in Eastern Europe. The Economy is slowing. Supply chains remain strained. And we are still in a pandemic. The problem for the Fed is they don’t have much to cut when they’ll eventually need to, having held rates at zero for 2 years. This is a very unique period on Planet Earth.

What the Fed did: The Federal Reserve Open Market Committee increased the overnight interest rate by a 1/2 a point for the first time in 22 years. It was telegraphed and widely expected. This followed the traditional 1/4 point hike back in March, which was the first hike since the Covid crash. The Fed Funds rate range is now 0.75%-1%. It’s still historically low. More hikes are ahead. Heading into the Fed meeting, the Market assigned a 100% probability of four 1/2 point rate hikes by year-end. That course still appears valid.

Chair Jerome Powell also announced plans for “quantitative tightening,” or allowing the central bank’s $9 Trillion balance sheet to runoff at a pace of $95 Billion per month, but not until September. It will be half that rate through August. That caught the Market off guard, to its pleasure. The pleasure didn’t last. Outright sales of securities haven’t been ruled out for the future either.

The Market was poised for an oversold bounce Wednesday, having priced in an aggressive Fed and perhaps a worst-case scenario for this meeting. This is a delicate balancing act for the central bank. It needs to combat inflation without crushing the already slowing Economy. We have seen this set up before. The Market tends to force the Fed’s hand.

The 2018 Fed tightening campaign anticipated 3 more rate hikes in 2019. The Market thought that was a bad idea. The Stock Market tanked to close out the year, culminating in the Christmas Massacre. You probably remember that. I’ll never forget it. The Fed never hiked in 2019, they actually cut as the Economy slowed. This is the same Fed in place today. And the Economy is already slowing. Powell said a 3/4 point hike is not being considered. Stocks took off when he said that. I was actually hoping the Fed did a 3/4 point hike. It might have forced the Market to get it over with and finally hit bottom. The volatility continues.

There’s a laundry list of issues to contend with. Inflation has continued to gain steam since the Fed’s tightening cycle began in March. The war in Ukraine spiked food and energy prices, which were already high. China’s strict Covid lockdowns put additional stress on supply chains. And don’t forget, there’s an election in November.

The Fed is in a tough spot. They have themselves to thank. They should’ve hiked rates in late 2020, after the Stock Market recovered. Instead, it kept injecting liquidity, which created bubble-like conditions. The central bank completely underestimated the severity of price pressures, calling it transitory for months. The Fed kept spiking the punch bowl, which kept the party going longer and more boisterous than it should have. The result is a pretty bad Market hangover.

Fed Chair Powell and crew are attempting to engineer a so-called soft landing, in which rates are raised high enough to keep the Economy from overheating but not so much that it triggers a recession. Nearly every Fed tightening cycle in modern history has led to recession. However, there were three periods where the Fed significantly raised rates without pushing the Economy into recession: 1965, 1984, and 1994. They’re trying to do that again.

Recession is commonly defined as 2 consecutive quarterly economic contractions. In other words, 6 months of the Economy shrinking in productivity. The last recession was quick and steep, occurring in the initial response to Covid. It was the deepest recession since the Great Depression. It was also the quickest ever in time, with the Economy recovering at the same speed that it fell.

The obvious economic comparisons from history drawn today are the 1970s and early 80s. The Oil embargo and the Iranian hostage situation shot the price of crude surging higher. The Economy shrunk while prices soared, causing stagflation. Fed Chair Paul Volcker effectively took down inflation, but he had to take the Economy down with it. That was the cost. Temporary pain led to future gain. Both those periods had recessions that lasted over a year. This current cycle, on top of those inflationary pressures, contained elevated Tech stock valuations, which rivaled the 2001 recession following the Dot-com bubble. That recession lasted 8 months. There’s a lot to deal with right now.

One major positive for the US Economy continues to be jobs. If you don’t have one and want one, it’s yours for the taking. The issue is companies can’t find enough workers. There are twice as many jobs available as there are people looking. 428K new jobs were created in April, much higher than the 150K expected. The unemployment rate remains at 3.6%, just above the record low. America’s Economy is strong. People are out and about and spending. Inflation is the problem. Prices are too high and the Fed is trying to knock them down without knocking the Consumer down.

The European Union launched new sanctions on Russian energy, including a phase-out of crude oil imports by the end of the year. That sent energy prices higher again. Oil hit $110 again. From the EU: “Let us be clear: it will not be easy,” European Commission President Ursula von der Leyen said. “Thus we maximize the pressure on Russia, while at the same time – and this is important – we minimize the collateral damage to us and our partners around the globe… because to help Ukraine we have to make sure that our economy remains strong.” It’s quite the undertaking.

Remember, 25% of Europe’s oil is imported from Russia. There are big differences in the level of reliance among member nations. Germany has the largest economy in Europe and is the largest buyer of Russian Oil & Gas. Generally, those closer to the Russian border are more dependent on its energy network. Poland and Bulgaria fit that criteria.

Moscow could also find other buyers looking to take advantage of the substantial discounts on its crude, like India and Turkey, and of course China. Russia is enjoying the higher prices. The Kremlin’s total oil revenue rose a whopping 45% to $180 Billion in 2022 as a rise in fuel prices countered the decline in production.

A barrel of oil holds 42 gallons. At $110, oil is $2.61 per gallon. Gasoline, a key refined product of oil, averages $4.25 per gallon nationwide and nearly $6 in California. Americans are feeling it at the pump as inflation is sucking valuable extra Dollars away from discretionary spending into the gas tank. For perspective, gas prices in California now rival the price of a gallon of Coca-Cola at Safeway. Milk is $7 per gallon.

Housing plays a big role in the US Economy. Americans feel richer and tend to spend more when their home value is high. Housing has been white-hot. There are increasing signs of some cooling. Home prices vs. incomes are at record highs, and with the rates spike, affordability is vanishing, making home price declines increasingly likely. 30-year mortgages have spiked from below 3% to over 5% in half a year. The key is, both lenders and borrowers have solid balance sheets and credit quality. Falling home prices would be unlikely to trigger a 2008-style financial crisis. That is very important. Cooling, no crash for housing.

Back to the Market: Stocks around the globe have been hammered as the Fed embarks on this QT cycle, especially in Tech. The Nasdaq fell 13% in April for its worst month since 2008. It’s down 23% on the year. The Yield Curve is no longer inverted and has steepened. 5s had been higher than 10s and 30s. But the front end fell while the back end rose. Higher rates will keep pressure on stocks. They hurt Bond prices too. There haven’t been many places for investors to hide.

I caught interviews with 2 of the smartest and most decorated investors of our lifetime this week. Their names are Paul Tudor Jones and Byron Wien. Tudor Jones called this uncharted waters with massive converging swells for the Fed to navigate. He likes Gold and other commodities here. Wien said he thinks there is a 50% chance of the Fed sticking a soft landing. He called this a truly unique period. Both are united in agreement that these are uncommon sets of circumstances coming together at once. It’s a tough Market.

Paul Volcker is a legend. As stated above, he broke inflation. Volcker didn’t care if the Economy went into recession. He had guts. Powell doesn’t seem as courageous as Volcker. But he does appear convicted in taming inflation, and it seems like he wants to do it quickly, before the midterm elections. Powell’s words: “Without price stability, the Economy doesn’t work for anybody.”

Americans have faced challenges throughout our nation’s history. This is another. It’s part of the cycle. Market corrections are designed to address excesses built up in the system. The Fed helped create the excesses. Now they’re trying to unwind it. The Market tends to overshoot on the way up and the way down. It usually takes the escalator up and the elevator down. That’s the Market way. We’ll get through it. Our defensive positioning remains. We’ve got this.

Have a nice weekend. Happy Mother’s Day to all you fantastic moms! We’ll be back, dark and early on Monday.


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