Macro Update – How Did We Get Here?
By Ken Hoffman on June 12, 2022
Let’s roll back the clock to the beginning of 2019. The economy was running well, major stock indices were setting new highs, and the Federal Reserve (the Fed) was lowering interest rates and keeping them low. By early 2020, rumors began to circulate about a highly contagious and lethal virus coming out of China. By early March of that year, much of the world closed down to prevent the spread of COVID-19; we were living through a real-life version of “Outbreak” or “Contagion”. During that period, the S&P 500 dropped 33.8% from February 19, 2020, to March 23, 2020, but it soon began to snap back. For much of the next year and a half, the major US stock indices moved higher & higher with the help of historically easy monetary policy, significant fiscal spending, and rapidly expanding profit margins.
What has happened this year to cause both the stock market and bond market to decline?
For much of the previous decade leading up to 2020, the Fed kept interest rates near zero to stimulate the economy and nudge inflation up to its stated 2% target. However, once the COVID-19 pandemic began, the Fed opened the floodgates on liquidity by lowering the Fed Funds Rate all the way to zero while massive federal spending bills were passed to keep both businesses and citizens afloat. At the same time, the global supply chain became entangled as businesses closed, the virus persisted, and employees got sick or even left the workforce altogether. These combined factors created a situation of too much money chasing too few goods – in other words, inflation. Not only did the inflation rate go over the Fed’s 2% target, but other factors contributed to the current rate of 8.6% (Consumer Price Index – May 2022).
What else has happened to exacerbate the current inflationary environment?
Russia’s invasion of Ukraine.
- Russia is a major producer of oil and gas with its primary customers in Central and Western Europe. The Western world is working to replace Russian energy, and in the meantime, prices have skyrocketed. Since Russia invaded, the price of oil has surged from $92.10 to $119.12 per barrel, an increase of over 29% .
- Russia and Ukraine are also major producers of grains and fertilizers. Since Russia invaded, wheat, for example, has risen from $8.78 per bushel to $10.40, an increase of over 18%.
China’s COVID-19 restrictions.
- The world’s second largest economy continues to experience lock downs due to its zero COVID policy. Shanghai, the country’s business capital with a population of over 28 million, is gradually reopening after a 2-month shutdown. Given China’s position in the global economy, these restrictions continue to have ripple effects on the supply chain.
Today’s economic environment has changed dramatically, and what worked especially well in 2020 has largely stalled and retreated this year. For example:
- Returns of growth stocks far exceeded those of value stocks for most of the last decade. That has changed meaningfully this year.
- The S&P 500 Energy sector was down 34% in 2020. This year it is up 58%.
- “Stay at home stocks” did so well during and after the pandemic – until they didn’t – as this recent article suggets. Here is a sample of a few:
Year to date, this has been a difficult year. What striking financial outcomes have we seen this year?
- The first quarter of this year exhibited the worst performance for the bond market in over 40 years.
- The FAANG stocks (Meta/Facebook, Apple, Amazon, Netflix and Google) lost over $1 trillion in market value in April.
- For the week ending May 20, 2022, the S&P 500 Index declined for its 7th week in a row; the longest consecutive weekly drop since 2001.
On the other hand, what is positive in the US economy?
- Unemployment is low. Through May, the unemployment rate is 3.6%. Most recently, 390,000 jobs were created in May and 436,000 were created in April. In other words, the economy is expanding, which increases the probability that the Fed can raise interest rates to tamper demand without throwing us into a deep recession.
- Rising interest rates are already affecting the economy which will lower demand and inflation. For example, through the end of May, lumber futures were down 52% from their high in March when the Fed began tightening monetary policy.
- As compared to the 2008-09 financial crisis, household and business balance sheets are generally strong, and risks in the financial system appear to be manageable.
Taking all of this into consideration, it is often difficult to see beyond the hard times of negative returns, particularly when this is happening for both stocks and bonds. However, one should consider the odds of this occurring relative to history. Here are the facts:
Of the 185 quarters since 1976, a negative quarterly return for both stocks and bonds has occurred just 19 times including the first quarter of 2022. Furthermore, over the same period, there are just four instances where both stocks and bonds are negative for two consecutive quarters with three of those four instances associated with a recession.
As always, thank you for your trust and confidence.
Ken