Macro headwinds are always important for markets and asset allocation. But today they are especially important with all that has happened in the world in the past two and a half years. For the past year, we have been dealing with the ramifications of a pandemic which has a) taken so many lives, b) disrupted global economic trade and supply chains and c) lead to some excessive government spending, a big factor in the high inflation we’ve been experiencing at the checkout counter. This then lead to interest rate hikes to correct an overheated economy. On top of this, a war has been waged and is still waging between Ukraine and Russia. The war has paved the way for massive geopolitical policy shifts, fuel shortages, exacerbating inflation and economic hardship even further.
Markets as they always do, quickly discounted these revelations and we entered a bear market a few months ago. But we’ve seen somewhat of a bear market rally since mid June. How are we fairing today? Well, the Dow was down about 1.9% today, the S&P sunk 2.1%, and the NASDAQ closed down even further at 2.6%. So what’s going on? Is the bear market rally over? Is this the first sign of worse to come? Where are we headed?
Well it’s typically hard to tell where markets are headed from one day’s trading, but we saw the S&P ending last week for the first time in the red in four weeks. So this is something. Currently, I think we are back in an even more uncertain period in markets. A lot is banking on the important indicators being released this week including flash manufacturing and services PMI, real GDP revision and PCE numbers. We will all be paying attention to Powell’s comments at the Jackson Hole meeting this Friday. Sentiment has somewhat changed after uncertainty around the supposed “fed-pivot.” Latest index results and Fed comments will give us some valuable insight. In my opinion, I don’t think the Fed will pivot or pause any rate hikes for the foreseeable future until there are undeniable indicators that inflation is moderating and I don’t think we are there yet.
Even if we were to see slightly lower PCE numbers for example, I believe the Fed will continue to hike rates come September, but we’re probably likely to see a 50-basis point hike rather than a 75-basis point hike. The Fed wants to make sure inflation is dampening, slightly lower numbers don’t necessarily indicate a moderating inflation. A 50-basis point hike would continue to tighten the economy, but would be measured enough to curb some very near-term economic fears. Fed communication is also very important and can give markets time to process, price in and deal with the monetary policy changes. To their credit, I think they’ve done a decent job in this regard.
If the numbers reveal an improving economic picture, especially on inflation, markets will price this in positively but still potential future rate hikes might depreciate the market. There are many probable events. In this scenario, we may see a small continuation of the rally and then market choppiness over the next few weeks and likely months. On the other hand, if the numbers reveal a stagnant or worsening economic outlook, particularly on inflation, markets will price this in negatively. The bear market rally will likely be over and the US economy may be entering a recession sooner rather than later.
If we start seeing large downward moves in major indices including retail spending, continued rate hikes will eventually plunge us into a recession. As bad as this may be, it could be the necessary policy if inflation continues to run rampant. Inflation is the central component here. There’s no doubt the Fed is looking at the broader economy and the effects of its tightening, but recessions as terrible as they are can be cycled out of in ways that inflation can’t. Inflation is like a water bug. It can retreat to its little home within your home, but reappear out of nowhere full of life. You think you got rid of it by giving it a whack only to see it alive and well hours later.
Then we have Europe which is looking like a nightmare. It’s going through a severe energy crisis influenced in large part by geopolitics and stands against Russia. Many European nations are experiencing problems with energy from weather-related events and outages, aggravating the crisis even further. Norway is even cutting its electricity exports to preserve its own supply. Inflation in the EU is the highest its been in twenty-five years. Nearly a month ago, Russia’s state-run energy company Gazprom cut Nord Stream One natural gas flows to Europe to just twenty-percent of capacity. By the end of this month they plan to halt gas supplies to Europe for three days, only deepening the crisis.
Soaring energy bills in the region will eventually make there way to most other goods and services as businesses will have to cover their increased energy costs through higher product prices. We are starting to see the beginning of this phenomenon. In addition to this, winter is near, and will make all of these issues much worse than they currently are, especially if Russia decides to decrease energy flows even further. Let’s not forget that the war in Ukraine will continue to have an impact on Europe and the broader globe, with increased tit for tat actions between Russia and the West seemingly likely the longer the conflict goes on and the more that wild events occur. Think not only of decreased energy flows from Russia, but also cyberattacks, spying and other moves which will have a negative impact on the economy and markets.
So Europe is looking very bad at the moment and going forward.
The US dollar is currently very strong. This has its upside because it becomes cheaper to import products putting some downward pressure on prices. But it also has its negatives. There has always been debate as to the impact of the dollar’s strength on markets and the economy, but we are in wild times. Europe’s energy crisis and worsening inflation coupled with a strong US dollar will make US products more expensive to buy in Europe. The energy crisis alone will likely reduce demand for US products. These will decrease US corporate earnings mostly for companies who generate a large percentage of their profits in Europe. Lower earnings tend to mean lower stock prices and could result in increased layoffs.
Uncertain times are upon us. As always, time will reveal everything.