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Market Perspective - Fed's Move on Inflation & Quantitative Tightening

July 06, 2022

Equities have been sliding since the beginning of the year as markets come to terms with the twin dragons of higher inflation and rising interest rates plus supply chain problems. For June, a capitulation move appears on the way with the 10-year treasury yields hitting an 11-year high while the NASDAQ declined 9.2%. The Russell 2000 index gained about 1.16% thanks to having made a low a month earlier. Crude oil prices pulled back from their $20 per barrel hi to $112 per barrel by the end of the month. Panic over Russian sanctions sent energy prices soaring. Economic data remains good but is also weakening enough that the different major instant traditional such as Merrill Lynch Goldman Sachs etc. given a range of 30% to 50% chance that the bear market will turn into a recession.

There is a saying, “it’s always darkest before the dawn.” In finance it’s taken to mean the investors overshooting the market on both the outside and the downside. Instead of reversing activity when fundamental change, market momentum pushes it in the same direction with the “herd behavior” following. We may be witnessing this with interest rate hikes and crude oil prices as spring turns into summer. In addition to economic and market forces at work, the Federal Reserve is working to lower inflation which has hit a 40-year high.

A little inflation recap – it started breaking out of the fence benchmark 2% rate in November 2020. Many stories appeared in financial and mainstream press articles about 10 about soaring building material prices for lumber, copper, plywood, etc. a contractor was bemoaning how the price of the ship plywood two years ago was in an $8 a sheet is now more than $35. By late 2021, inflation had hit a 40-year high. Since them the Fed has raised its interest rate 1.75%, quantitative easing program. The Fed is expected to raise another 50 to 75 basis points in July and continue its quantitative typing program.

Investors recognize the Federal Reserve has turned hawkish and inflation will batter the market. By June most investors have recognized that high inflation is bad news for everyone as well as the stock market and economy. This realization may have come from the University of Michigan’s consumer confidence survey report for June showing consumer confidence and all-time low. The Fed has said it is strongly committed to bringing inflation back down to 2%. Overall the market took the news positively in the immediate aftermath of the announcement. Along with the latest Fed interest rate hike, Federal Reserve started its quantitative tightening program in June by shrinking its balance sheet $47.5 billion per month till September when it is scheduled to double that amount to $95 billion. While the past is no guarantee of the future, the last time the Fed tightened by these amounts in late 2018 crude oil fell 44% as a result.

Atlanta Federal Reserve’s GDP model projected zero GDP growth in mid-June, down from a 0.9% a week earlier. It’s been suggested, if this trend holds, the next report will likely be negative and that would mean US is technically in a recession-defined by two quarters of contractions. However, the first quarter report was also weighed down by a surge in imports which fell in April. That coupled with higher oil and food prices consumer spending was diverted to domestic products. Given that’s the case, the assumption is that trade deficits should further decline and hopefully the economy will avoid second negative quarter averting a technical recession.

If the Fed can hold the rise of inflation or the economy weakens, the outlook for energy and commodities should turn bearish. Similar periods of Fed Tightening have produced large declines in the price of oil as previously stated or any moves towards peace – not expected – in Ukraine would also add momentum for lower Crude oil prices. At some point, higher prices are their own worst enemy because they curtail demand while also attracting more supplies. Following that scenario, if inflation crude oil slide, other sectors could see their fortunes rise towards fall or winter including beaten-down stocks. In addition, technology, communications, healthcare funds, and consumer discretionary products could be positioned well for a rally.

Memories are short, let’s not forget the stock market suffered corrections in 2011, 2015, 2018, 2020 and 2022. While stocks often needed at least a year or more to hit a new high, all the prior corrections are evidence that make it wise to invest via dollar cost averaging.