Equity markets staged a relief rally this week on encouraging signs that inflation and consumers' expectations for future inflation may have peaked. Prices of commodities such as lumber and copper have turned lower, suggesting inflationary pressures could be decreasing. The University of Michigan's Consumer Sentiment Survey for the end of June showed a slight decrease in consumers' expectations for future inflation. http://www.sca.isr.umich.edu/files/chpx1r.pdf If these trends continue, the Federal Reserve may not need to raise interest rates as aggressively.
Everything comes down to the Federal Reserve's monetary policy. Tighter monetary policy slows economic growth, leading to lower corporate earnings and stock prices.
- COVID-19 interrupting supply chains from China leads to inventory constraints, higher prices, higher inflation, and the Fed tightens monetary policy.
- The war in Ukraine leads to reduced production of grains and other raw materials, which leads to food shortages, higher food prices, higher inflation, and the Fed tightens monetary policy.
- Sanctions and bans on Russian oil & gas lead to supply shortages, higher energy prices, higher inflation, and the Fed tightens monetary policy.
- When the labor market is too tight, employees have more bargaining power, increasing competition for workers. Higher wages are passed on to consumers through higher prices for goods and services. Prices rising too quickly leads to higher inflation, and the Fed tightens monetary policy.
Inflationary news will tend to move equity markets lower, and information suggesting inflation may have peaked or could move lower will support higher equity prices.
I am cautiously optimistic that markets will end the year higher than current levels. Still, I would feel better hearing that the Fed sees enough evidence of inflation moving towards its target and that monetary policy will become less aggressive. The Federal Reserve meets again on July 26th and 27th, when they are expected to raise interest rates by .5% to .75%. There is no meeting in August, and inflation may have peaked and begun rolling over by their September meeting. As we move through the Summer, there will be an increased focus on the mid-term elections.
When Americans become pessimistic and frustrated, there is a tendency to blame politicians, and leadership change often follows. The 2008 recession began under a Republican administration, ushering in a Democrat President and super majority in Congress. Americans became frustrated with the legislative agenda, and in the 2010 mid-term election, the Democrats took a "shellacking," as described by President Obama. The pendulum swung towards Republicans in 2016 and Democrats in 2020. I give this history lesson to say that as we approach the 2022 mid-term election, the odds are increasing that there could be a shift in the balance of power in Congress. When leadership changes in Washington in either direction, a hope can form that a positive change in the country's direction may follow. Secondly, a divided government can be good for markets as there is a reduced possibility of significant legislative changes allowing companies to plan better.
Outlook – My view hasn't changed. There is a risk that we are in or on the cusp of a recession. The Federal Reserve does not have a good track record of raising interest rates without causing a recession. Given the labor market's strength, a recession would probably be short, mild, and more of a technical event. It is just as likely that the economy will slow enough to bring down inflation, and a recession will be avoided. Elevated market volatility should be expected, meaning sharp moves down and up. Market sell-offs should not be interpreted as the end of life as we know it, nor should rallies be a reason for euphoric celebration. The economy and markets are going through a transition; it will be messy and take some time. We've been through transitions before.
This would be an excellent time to review your spending plans. If you receive monthly distributions from investment accounts that are recalculated annually, your 2023 distribution amount could be less. I hope you found this helpful. I will continue to monitor markets and the economy and keep you informed.