Global markets have experienced a turbulent eight months this year. The S&P 500 declined greater than 20% in June, marking an official bear market in 2022. This bear market has largely been caused by a series of unexpected rate hikes implemented to combat persistently high inflation. One year ago, the market anticipated a raise in rates of just 0.25% for 2022. As of September, the Federal Reserve has already hiked rates by 2.25%, with an additional 1.50% increase anticipated before the end of the year. This rapid change in monetary policy has redefined inflation as the top threat to economic stability, upending capital markets in the process. Given that the market has already adjusted its inflation and interest rate expectations, investors have constructed bull and bear market cases for the end of 2022 and into 2023.
The case for a bull market lies in the belief that the economy will experience a “soft landing.” This is the theory that the economy can withstand a restrictive monetary policy without contracting. This thesis makes sense when viewing inflation from a supply standpoint. In their view, high inflation is a result of supply chain disruptions caused by COVID-19, lockdowns in China, and the war in Ukraine. As supply chains stabilize, more supply will enter the market to offset demand and inflation will moderate. This will allow interest rates to pause or even decrease, which will spark a rally in the market. The bulls also have recent inflation developments on their side. Last month, the consumer price index (“CPI”) was flat (0.0%) on a month-over-month basis. This month, inflation increased by just 0.1% on a month-over-month basis. Additional rate increases may not be needed if inflation is already under control. Furthermore, market bulls have a strong economy on their side. The hot labor market, healthy consumer, and resilient corporate earnings indicate that the economy is strong despite the tightening money supply. Ultimately, the bulls argue that supply chains are stabilizing, inflation is moderating, and the economy remains strong. In the remainder of 2022, the bulls will search for cooling inflation data and strong corporate earnings to build a sustainable rally throughout next year.
On the other side, bears believe in a “hard landing,” where rising rates and quantitative tightening lead to an inevitable recession. This thesis views the economic cycle through a historical lens (it is often said that the four most dangerous words in investing are “this time is different”). Out of the eleven periods where the Fed has raised rates since 1965, they have only been able to engineer a soft landing one time. Additionally, the yield curve is inverted. Shorter duration treasury bonds are yielding more than longer dated bonds. An inverted yield curve has been a very strong indicator of recession historically, predicting nearly every recession since 1955. The bears also present the fundamental argument that high inflation stems from a demand issue, not a supply issue. They argue that the Federal Reserve needs to put a dampener on the economy for an extended period of time to counteract the unprecedented increase in the money supply from COVID-19. The bear assessment that rates will stay “higher for longer” increases the probability of a future economic downturn. Finally, the bears note that the high inflation in the economy is more structural and “sticky” than the bulls would like to believe. High inflation has, in part, been due to outsized wage gains and a rapid increase in housing prices. These price increases are due to structural imbalances in the labor and housing markets – they are not temporary and could lead to an upward price spiral if the Federal Reserve is not tough on interest rates. The bears conclude that this bear market is no different than prior bear markets, and that historical precedent, persistently high inflation, and an aggressive Federal Reserve will drive the economy into recession.
Whether the bull or bear case proves to be true, one thing is certain – the market is preparing for a potential storm. While higher interest rates have reduced stock valuations and led to a market pullback, the economy remains strong, inflation is moderating, and supply chains are slowly returning to normal. On the other hand, uncomfortably high inflation, a massive increase in the money supply, and economic history suggest that storm clouds are brewing and a recession looms on the horizon. Inflation data, corporate earnings, and Federal Reserve policy released over the next two months will provide significant insight into the state of the economy. Better than expected data could suggest a soft landing and prove the bulls right. Higher than expected inflation readings or weakening economic and earnings data could portend a hard landing and impending recession.
Halfway through September and entering the most treacherous stretch of the year for equity markets, we expect continued volatility and violent swings in sentiment. Investors seem to have priced in a slowdown in growth or perhaps even a mild recession. While this more sanguine view would leave markets well positioned for a melt-up into year end, we cannot ignore the risk of a hard landing and the potential destruction it would leave in its wake. We believe our overall investment positioning is balanced for this environment with elevated cash and defensive positions offsetting the more exposed parts of our clients’ portfolios.
As always, please do not hesitate to call us if you have any questions or concerns regarding the state of the economy, volatility in the market, or your current portfolio positioning.
The NEIRG Team
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