— 2022 Q3 UPDATE —
Summary:
The Fed is attempting to reduce inflation by increasing interest rates which reduces the value of financial assets and slows credit creation. The problem is that neither high financial asset values nor excess credit creation were the culprits for this inflationary environment, therefore, reversing these policies, while potentially warranted for other reasons, are unlikely to reduce inflation without producing a recession. Inflation was created by fiscal policy and supply shocks. Fiscal policy is to blame by putting money in the hands of consumers which resulted in the highest level of inflation adjusted savings ever recorded at a time when the world economy was just beginning to reopen. Therefore, as those issues continue to naturally correct, inflation should cool down over time with the major caveat being the oil markets and the Russia-Ukraine war.
Q3 2022 Index Returns:
Source: Y-Charts
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
Year-to-date Returns, up to 9/30, Index Returns:
Source: Y-Charts
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored and ranked for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
General Market Update:
Quarter 3 of 2022 saw downturns in major indices similar to the previous 2 quarters of the year. With inflation (as measured by CPI) proving to be stickier than many thought, the Federal Reserve (Fed) has continued to raise interest rates and offload their balance sheet. Meanwhile, supply chains began to normalize while oil prices remained high even though the U.S. has flooded the oil markets by unleashing an unprecedented amount of oil from the strategic reserves. The equity and bond markets responded to these events with increased volatility and negative returns.
On the Fed:
The Federal Reserve is attempting to combat inflation through raising their target interest rate (Fed Funds rate) and letting outstanding treasury and mortgage-backed securities mature off their balance sheet. From July 1st to September 30th, the Federal reserve increased the Fed Funds rate from 1.58% to 3.08% and reduced the securities held outright on their balance sheet from $8.476T to $8.372T, which amounted to a $104B reduction. However, the big liquidity drain from the system is happening from a reduction in reserves in the banking system because the average saver is taking their deposits out of the banks and putting them with money markets who are paying higher rates than savings accounts. Money markets are using the Fed’s overnight reverse repo operations to generate returns, and this process drains liquidity out of the banking system. Reserves have dropped over $1T year-to-date, mainly due to this process, and this is a process the Fed has very little control over.
Source: FRED
Source: FRED
The actions by the Fed, combined with the liquidity drain in the banking system is expected to combat inflation by reducing the demand for credit and reducing the value of financial assets due to increased interest rates. This in turn reduces wealth which is supposed to reduce demand for goods and services. This process is expected to tamper inflation and if the process is extreme enough, it most likely will. However, the difficult part is trying to toe line between reducing inflation and avoiding an unnecessarily deep recession, which remains to be seen if it can be avoided.
On interest rates:
Interest rates along all tenors of the yield curve have increased precipitously this year, mainly due to the Fed’s operations. The following chart is the yield curve at 4 different time stamps over the past 2 years, which accentuates the transformation.
Source: Y-Charts
An increase in the yield curve reduces the present value of financial assets and it reduces the demand for credit within the economy. Both effects are desired effects by the Fed in the hopes they can reduce demand for goods and services throughout the economy which will bring down inflation, which has remained above 8%.
Source: U.S. Bureau of Labor Statistics
However, there are skeptics of the Fed’s power to adequately bring down inflation because inflation was due to a combination of fiscal stimulus, negative real interest rates, and supply shocks. Increasing interest rates and reducing liquidity in the banking system will reduce the wealth effect by reducing asset values (it already has), but increased asset values were never the main issue when it came to inflation since this wealth was mainly tied up in the financial system and was not being used to pay for goods and services. This is why quantitative easing was not causing inflation as measured by CPI during the 11 years the Fed was aggressively doing it from 2009-2020.
Inflation was mainly caused unprecedented fiscal stimulus that put cash directly in the average consumers pocket which gave them more spending power and the ability to delay coming back into the labor force. This combined with supply chain shocks and commodity shocks that created the perfect inflationary environment. Essentially, the Fed provided a ripe environment for financial asset valuations to skyrocket which made many on paper millionaires and billionaires which undoubtedly produced some level of increased demand, but the real culprit of inflation as measured as CPI has always been outside their control. Therefore, the Fed may be making a policy error by raising rates until inflation is under control when they may not have the tools to fix the problem. The Fed is essentially trying to perform complex surgery when time to naturally heal is the real thing the patient (economy) needs.
On Supply Chains:
Luckily, one of the main culprits of the inflationary problem is starting to resolve. The following chart shows the world container index, which shows the average cost of a US 40ft container being shipped on a cargo ship.
The average price of a container skyrocketed after the worldwide economy began to open because of the difficulties of restarting a complex system that optimizes for efficiency. Depending on the business, the increase in shipping prices were at least partially passed onto consumers which increased the prices of goods. These increased prices were met with demand for them because of the dual effect of consumer euphoria from reopening and the highest recorded level of inflation adjusted savings on record.
However, now that direct government transfers have slowed and consumers have been spending their savings, the gross private savings adjusted for inflation are below pre-pandemic levels. The reduced demand combined with increased functionality of the supply chains reducing shipping costs poises the economy for a potential slowdown of inflation in the next year. This is the natural healing of the economy which had little to do with Federal Reserve action in the first place, and it is resolving irrespective of the Fed’s policy.
Source: FRED
However, one of the main issues with inflation coming down after gross savings and supply chains correct themselves is the Ukraine-Russia war and the resulting oil shocks that have resulted. The worldwide energy crises is a potential factor that could prolong inflationary pressures, especially as Russia increasingly uses energy as a weapon against the West and the U.S. plows through its strategic reserves. This topic will be a main point of focus in the following quarter’s update as the consumer demand and supply shock issues continue to sort themselves out, all eyes will be on the energy markets during the winter months.
Conclusion:
Here at K2 Financial Partners, our main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when inflationary pressures are at the forefront. Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns. At the end of the day, we are here to help you!
Sources:
- Biden Administration Clamps Down on China’s Access to Chip Technology - The New York Times (nytimes.com)
- 12-month percentage change, Consumer Price Index, selected categories (bls.gov)
- Federal Reserve Economic Data | FRED | St. Louis Fed (stlouisfed.org)
- Drewry - Service Expertise - World Container Index - 13 Oct
- Dashboard (ycharts.com)
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. Diversification does not guarantee a profit or protect against a loss
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