Broker Check

WIA BELIEVES | Inflation is the Driver of Market Volatility

| October 20, 2022

Markets remain extremely volatile with 1% - 2% moves in market indices happening almost daily. Yet for all the market noise and volatility, this remains a broadly uncomplicated market. Following I’d like to add some perspective and insight as to what we believe is happening in the economy and markets.

This is not 2008, where years of dereliction of duty by risk management departments in banks, insurance companies, Fannie Mae/Freddie Mac and other organizations resulted in a nebulous black hole of insolvent loans based on inflated home prices, leading investors to have to “guess” who was solvent and who wasn’t. This is not 1998, where an explosion of emerging market debt eventually collapsed under its own weight, sparking a liquidity and foreign exchange crisis that required action from global central banks and the bailout of a massive hedge fund (LTCM). And this is not 2010/2011 where decades of fiscal irresponsibility from southern European nations collided with German frugality and sparked a sovereign bond crisis that left investors wondering if the newly formed EU would band together to bail out Greece or disband and scuttle the EMU.

The point being, these were existential crises that confronted investors with a stark lack of information—a veritable black hole into which investors peered and wondered how far contagion would go. This current environment is not that. This is much more “run of the mill” - the global economy has a big inflation problem. And the way to stop rising prices is to slow the economy. What is bad news (slowing growth/recession) is now good.  Hmmm.

Recessions are better than entrenched inflation (neither are good, but the former is better than the latter) so central banks will hike rates to cool inflation to a tolerable target (not 2%, but something probably between 3%-4%). Those rate hikes will cause recessions, which will help fix inflation. When that’s done, these same central banks will cut rates, stimulate the economy, and growth will resume, albeit with a higher relative level of inflation.

It’s a process we must endure, and last week we learned that we’re not quite as far along as we’d hoped. Inflation is not yet declining materially, which means we must endure more rate hikes and a slowing of the economy to get to the proverbial “other side”. Of note however, while the daily headlines will certainly remain challenging for many months, history says that movement in market direction precedes the real-time news by 6 to 12 months.  So the uncertainty now is how long the fight against inflation will last, and how much of that bad news is already built into stock and bond values.

Unfortunately, being at this stage of the process leaves the markets susceptible to shocks, and we’ve endured several this year that have made stock and bond market declines worse. The first shock was Russia invading Ukraine, which made pretty much everything worse for the global economy via higher commodity prices, higher geopolitical risk premiums, and general anxiety. The second shock came when China decided to do things differently than the rest of the world (what a surprise!) and continue to lock down their cities and economies to stop the spread of something that can’t be stopped (COVID). This hasn’t worked, so the global economy must deal with a “stop/start” Chinese economy that resembles the lurches and jerks of a car stalling out. The third shock came from the U.K. via PM Truss’ historic bungling of the inflation problem, which caused an unwelcomed spike in global bond yields and has led to Prime Minister Truss resigning less than two months into the job!

While those shocks are unneeded and ill-timed, at its core we are still dealing with an inflation problem that the Fed and other global central banks will fix, and that fix will bring slower growth and lower asset prices.

Here is what matters. For markets to get some footing, we must get proof inflation is receding. There’s now anecdotal proof of it from companies and economic data, but it’s not conclusive yet—and the Fed will continue to hike rates until that decline is conclusive. Once that drop in inflation is conclusive, markets will likely stabilize.

So, we will continue to watch inflation closely. In the meantime, we continue to advocate keeping volatility to a minimum through investment in tactical managers and a balanced portfolio of short-term income and diversified equity classes. The bottom is likely not yet in, and none of us should be shocked if the S&P 500 falls another 10% to 3,300 (3,657 today) if inflation gets worse, the Fed gets more hawkish or we get more macro shocks. For now, we should view any rally towards 4,000 as a short-term rally that is part of the technically necessary “searching for a bottom process”.

But remember, the root cause of this bear market is inflation. The Fed is going to break it (don’t fight the Fed) and then they will cut rates and re-stimulate the economy—so this tumult will come to an end, and from that will create a 2000-2002-type opportunity for investors to capitalize on a reinvigorated economy.  As I have shared with each of our clients, we are positioned currently to manage such volatility, as well as to be aligned to a cautious extent to take advantage of things when they do turn around.

Please let us know if you have any thoughts or questions about your investments or this commentary.