December 23, 2022
Riding out the turbulence

The ‘Santa Claus Rally’ is something investors have learned to hope for every year. As illogical as it sounds, this rally appears in the weeks leading up to December 25, and it often brings a nice bump in gains for the end-of-year stock market numbers. Unfortunately, it doesn’t look like investors will be receiving any gift of the kind this year. The reason: Wall Street is holding on to concerns over inflation, Fed policy, and recession risk.

I’m still surprised at last week’s downturn, especially considering the recent news that could have easily pushed the market in the opposite direction. First came a rather benign report on the Consumer Price Index (CPI), including data that seemed to indicate a slowing of inflation—and that actually came in under estimates that already incorporated some slowing of inflation. That, in turn, gave the Fed the wiggle room needed to opt for a smaller rate increase compared to their recent rate decisions. The Fed did just that last Wednesday, raising its target federal funds rate by just half a percent—a small reprieve from the incredible pace of rate hikes throughout the year. So why the turbulence? Why isn’t Santa Claus rallying this year? Here are three factors that are (probably) creating such bad weather for the market today:

  1. Inflation
    While the pace of inflation (as indicated by the CPI) is certainly slowing, market demand continues to outpace market supply. When that equation is out of balance, inflation is inevitable. One piece of the puzzle is ongoing supply chain constraints. Supply chain disruptions have wreaked havoc for consumers since the start of the pandemic, and while they have eased somewhat, issues prevail thanks to labor shortages, inventory hiccups in the retail sector, and the simple fact that consumers are still clamoring for goods—despite higher prices. While fuel prices have dropped, energy/commodity-related supply issues also remain. Though improved, this problem isn’t going away any time soon.

  2. Monetary policy
    Easy monetary policy has certainly had an impact on market demand. To address the global financial crisis and support the economy, the Fed cut interest rates to 0% and left them at rock-bottom levels for an historically extended period. Naturally, investors were worried about inflation, but there was no sign of it in the markets, especially in bond yields which were abysmally low. The Fed tried to normalize interest rates from 2016-2019, but then came the pandemic—an ‘exogenous’ shock so amazing it could have been designed by the authors of economics textbooks! The monetary policy response was a massive increase in the money supply through a variety of programs, each aimed at putting piles of cash in the hands of consumers to stimulate spending and keep businesses afloat. This graph illustrates the impact:

    Source: Bloomberg

    In short, it worked. Perhaps a bit too well. When elevated levels of inflation first appeared, the Fed reacted by justifying the rise as covid-related. From the Fed’s perspective, the ‘blip’ was transitory. Once the Fed finally understood and acknowledged that inflation had officially arrived and was likely to remain, monetary policy was quickly changed to focus almost solely on reining in inflation through increased interest rates.

    When will this revised monetary policy start making a difference? History tells us that it takes about a year of restrictive monetary policy before inflation begins to respond to the actions of the Fed. The first, tepid rate hike of 0.25% was put in place in March 2022. Since then, the Fed increased rates 0.50% in May, followed by four hikes of 0.75% each. In short, this has been the fastest pace of rate hikes in history! Will that fact bring change faster? Will we need to wait another 3-4 months to see an impact on inflation? Hopefully, the Fed’s aggressive action will help the economy and the markets change course sooner rather than later.

  3. Recession fears
    If you’ve been reading about the predictable course of what happens after inflation rises and the Fed increases interest rates, you know that recession—that word we all tend to fear—is increasingly likely at this point in the economic cycle. By upping rates, the Fed hopes to slow demand. When that goal is eventually achieved, a by-product is an increase in unemployment, which further reduces demand. The following chart shines light on just how extreme the job market has been over the past 2 years, the peak in March 2022, and the reduction in job openings since the Fed’s initial monetary policy action:

    Source: US Bureau of Labor Statistics

    Interestingly, even in the face of hawkish monetary policy, the unemployment rate itself has held steady. This is most likely explained by the still-elevated number of job openings; even when workers are laid off, there are many options for re-employment. Will that keep the National Bureau of Economic Research, the body responsible for the official declaration of recession, from announcing that recession has arrived? It’s doubtful. The weightier indictor of a recession is a broad slowing of economic activity, sometimes summarized as two consecutive quarters of negative GDP growth. But whether a recession becomes official or not, tougher economic times are likely headed our way. The question the markets are digesting now is just how tough—and how long—that era will be.

All that said, the sharp fluctuations in market sentiment are likely to continue. Market participants (read investors, but primarily institutional investors that tend to be the key drivers of financial market trends) are bifurcated, with some calling for a long and deep recession, and others projecting a short and shallow recession. Until the economy delivers some clarity, it’s going to be a bumpy ride. Still, there are plenty of reasons for optimism:

  • Recent figures indicate that inflation is abating, just as previously inflated stock prices have re-rated to lower levels of earnings. If inflation continues to abate and earnings are more resilient than expected, stocks could perform much better than expected. (We can only hope!)
  • On the bonds front, the tough bond market in 2022 was all about interest rate risk—not credit risk. With yields already elevated, investors can have more confidence putting their money to work with higher yields and lower interest rate risk.
  • Alternatives may also provide some benefit to investors. The multi-strategy/alternatives that we use at LCM are designed to improve portfolio-level risk-adjusted returns. Some of our alternative strategies will participate with the general direction of markets (both stocks and bonds), but with lower levels of risk. Other strategies (which we call ‘satellite’ strategies) have the opportunity to perform independently of the direction of stocks and bonds. We are constantly exploring how to use alternatives within our portfolios to grow and protect your assets.

As we near the end of 2022, we see good things ahead. Yes, it may take some time for the current situation to play out in full (so don’t expect a Santa Claus rally to ‘save’ annual returns this year!), but as every investor knows, even down markets offer opportunity—and those who have the fortitude to ride out the storm usually come out ahead in the end. Hang in there, and if you have any questions, don’t hesitate to reach out. Our team will be taking time to enjoy family and friends during the holidays, but we are never more than a phone call away.

Have a wonderful holiday and a happy, prosperous New Year!


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