The best thing I can say about this week is the weather is absolutely beautiful here in Birmingham as I type this on Friday morning. Other than that, if it could go wrong this week, it mostly did. How is that for a breath of fresh air?
Behind much of the recent unpleasantness is a simple fact. There has always been and should always be a strong positive correlation between inflation and interest rates. After all, the latter are nothing more than the price of money in the economy. Unfortunately, there has been a disconnect between the two for some years now.
This means the pain has been sharper than it would have been had bonds performed normally. I hope that makes sense.
This begs the questions: how much longer will interest rates continue to climb? How much longer will bonds take it on the chin? When will investors feel comfortable getting back into the markets again? After all, stock market valuations are as attractive now as they have been in about a decade. Still, there is a lot of red ink in the markets.
Okay. Here is the underlying answer. Interest rates will continue to climb as long as inflation seems to be unabated. The Consumer Price Index (CPI) for last month really sent a chill down investors’ backs when it came in higher than anticipated. Since then, interest rates and asset prices have gone sharply in opposite directions.
Inflation. It sure seems like we are talking and writing a lot about it. Doesn’t it? Everything seems to be up in price. There doesn’t seem to be any end in sight. Pundits are on the TV proclaiming it is a systemic, long-term problem due to the tight labor markets and wage pressures. Governments seem to be counterintuitively addressing the issue by throwing more money at the problem. Inflation seems like it is here to stay. Am I right?
Whew. The list of woes and the bricks for our wall of worry are stacking up faster than I would like. Heck, I don’t even want those things in the first place.
I have made several presentations this week. After each one, people have told me I am more optimistic than they thought I would be. However, any economic prediction which isn’t ‘wrack & ruin’ seems pretty rosy when everyone else is preaching Doomsday.
However, as I wrote last week and extensively prior to that, it is just the odds. What are the odds inflation will continue to trend higher as commodity prices fall through the floor? What are the odds prices will skyrocket when the money supply is barely growing? What are the odds businesses will continue to sit on their massive amounts of inventory as their financing costs mushroom? What are the odds employers are going to pay workers more than the perceived value of their output? What are the odds US consumer demand will continue to be robust after such a strong run AND as prices have gotten higher?
Frankly, I don’t think the odds on any of those questions are very good. Of course, stranger things have happened. After all, nothing is certain in life but death, taxes, and a sale at Jos A Bank.
So, by the middle of next year, perhaps at the latest, we will see a significant improvement in inflation. Personally, I believe we will see by the end of this year, but I want to make my odds even greater. This means interest rates and inflation will eventually converge. Once this happens, the former will likely no longer be on such a sharp upward trajectory.
Don’t get me wrong. This doesn’t mean prices are going to fall, only slow down. Fortunately, that should be enough to calm things down in the bond market, which will put the stock market to rights. Since the markets are often forward looking, these might come sooner than later, although predicting the exact timing is impossible.
The best thing investors can do IF they want to rein in inflation, which will curtail interest rates, which will give a boost to stocks (for a variety of reasons) is to push back on massive deficit spending. To be sure, the government can be a silent hand which smooths out the economic cycle and builds a base during a downturn. However, it can also can massive problems with extreme profligacy and fiscal imprudence.
With inflation being proximate cause of the recent economic unpleasantness, let’s focus on tackling that than buying votes. If that is possible in an election year. This means no more throwing proverbial gasoline on the inflation fire.
Drawing this to a close, we know what the problem is. It isn’t a mystery. Personally, I think a lot of the pieces of the puzzle to solve the problem are in place, or soon will be. I suppose that makes me something of an optimist. I have also been doing this long enough to know markets can get spooked and un-spooked pretty easily.
Perhaps a lower than expected PCE Deflator (another inflation gauge) next week could be the trigger. IF that isn’t it, maybe stingy PPI and CPI readings the second week of next month will turn things around. Farfetched? Well, that is exactly what happened this month…just going in the opposite direction.
I suppose this realization is a reason why I will hold my nose and enjoy this beautiful fay.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
Chief Economist & Outdoor Lover
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.