The past two weeks have produced a powerful, worldwide rebound by equity prices. Markets reached extremely oversold conditions after persistent weakness eroded prices during the first half of March, followed by an explosion to the upside. Meanwhile, war in Ukraine is unabated, commodity prices remain elevated, albeit below recent panic highs, short term interest rates have risen relatively sharply, and selected benchmarks are close to new all-time highs.
Losses from the early January highs have been substantially mitigated by the upswing since mid-month, but as the end of the first quarter of 2022 approaches, most widely followed broad equity indexes remain in the red for the year. The Dow Jones Utility Average is the sole exception, which last week posted new highs.
Utilities are hybrid securities, which have characteristics of both bonds and equities. The high dividend yields attract investors seeking income and the current robust pace of US economic activity is ensuring strong demand for power.
Despite fears that Federal Reserve tightening could inhibit economic expansion, new highs for the Utility Average suggests investors may believe the Fed would relax its newly aggressive posture if growth rates started to fade. Closing prices for the 15 Dow Utilities from January 1, 2021, through March 29, 2022, are shown below.
Bond investors have not been pleased by recent market action. Inflation remains a deep concern after both the Consumer Price Index (CPI) and the Producer Price Index (PPI) readings for February reconfirmed that roughly 10% annual inflation rates remain in place. There is little in the recent behavior of commodity prices, Congressional spending, or money supply expansion that suggests the trend will reverse in the foreseeable future.
Historically, purging inflation from the economy has required interest rates to move above the inflation rate. This would imply a 10-year Treasury note yield greater than 7%-8% and a 30-year Treasury bond yield of at least 11%-12%. Clearly, with both these benchmarks currently yielding approximately 2.50%, it is unlikely that bond prices are headed anywhere but lower over the next several quarters if the Fed truly intends to back its words.
Real interest rates (nominal rate-inflation) remain negative, and inflation is likely to continue compounding, pushing fuel, energy, and food prices higher. So far, companies have been able to increase prices to compensate for elevated raw materials prices, protecting profit margins for the first and likely the second quarter but this workaround has limited life before consumers begin to cut back all but the most essential purchases.1
Profits in myriad industries have been impacted by rising materials costs, and consumers’ budgets have reluctantly absorbed a higher cost of living, but although many have seen wages rise over the past few months, workers are experiencing a steady loss of purchasing power.
Buried in the February Employment Situation Report was the fact that wage expansion last month was flat, which, accounting for inflation, means that incomes declined at an annual rate close to 10%.2 This situation is not sustainable.
Mr. Chairman Powell has become increasingly “hawkish” over the past several months after abandoning his contention last summer that inflation was expected to be transitory. His latest comments, early last week, opened the door for a .50% rate increase in May after this month’s .25% upward nudge.3
Powell will eventually face a dilemma as higher borrowing costs impact companies that rely on short term financing to conduct business. In past inflationary episodes, the “cure” for inflation has led to a slowing of economic growth, followed by recession.
In recent days, the Treasury yield curve has begun to invert, i.e., some short rates are now above longer term maturities. The five-year note is yields roughly 10 basis points more than the 10-year note and is within +/- 2-3 basis points of the 30-year bond yield. This is a manifestation of tighter short to intermediate term credit and can be expected to impact most consumer borrowing, including mortgages. The inversion is clear between the five and ten year notes as is the extremely narrow range of spreads from the two-year note through the 30-year bond.
Every recession since the 1960s has been preceded by an inverted Treasury yield curve, with the inversion appearing 12-15 months before recession. Unlike the present, however, most inversions have been characterized by three-month rates climbing above the 30-year, which does not appear likely given the Fed’s current expressed intention to increase short rates by only 2-2.5% by year end.
This causal relationship is not etched in stone. While inversions have occurred before every recession, not every inversion has been followed by a recession. It’s a version of the Wall Street saying, “The stock market has predicted 12 of the last 9 recessions.”
The Fed has become progressively more aggressive in its rhetoric and apparent resolve to conquer rising prices. But without substantially higher borrowing costs, which are likely to eventually inhibit economic growth, consumers can expect stagflation as the most likely result of current Fed policy: Inflation will remain intractable, purchasing power (real wages) will decline, and the global economy’s growth rate will likely be subpar.
Investors have enjoyed a two-week surge in equity prices, accompanied, atypically, by higher interest rates. We see little on the near term horizon to suggest that inflation will diminish or that interest rates will cease marching upward. Regardless of short term events, however, investors who focus on their long term plan and ignore short term volatility will maintain the discipline so critical to long-term financial success.
1 “Big companies aren't shy about raising prices,” www.cnn.com, March 2, 2022. 2“Real Earnings Summary,” www.bls.gov, March 10, 2022. 3 “Powell Says Fed Will Consider More-Aggressive Interest-Rate Increases to Reduce Inflation,” www.wsj.com, March 21, 2022.
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