A Textbook Example

We remember many people saying that the end of the pandemic would lead to a period like the Roaring 20s. Well, we did get at least one year of exuberance in 2021 with U.S. households’ net worth surging by nearly $40 trillion (see figure 1). However, we are now dealing with the hangover, which is inflation. If you’re not an economist, don’t worry, inflation is easy to understand. It is created when too much money is chasing too few goods. As such, it should not have been surprising that policymakers would generate inflation as U.S. Federal spending surged by $5 trillion (a $1.9 trillion covid relief bill was passed in March 2021 under President Biden and a $3 trillion aid bill was passed under President Trump and the split Congress in 2020) and the Fed expanded its balance sheet by $5 trillion amid disrupted supply chains (see figure 2). This was then worsened by the unexpected invasion of Ukraine. Hindsight is 20/20 on this one.

This chart shows the Household and Nonprofits Organization's Net Worth in Billions from 2000 to 2022 year-to-date.

This line chart shows the U.S. Federal Debt vs. the Federal Reserve's Balance Sheet from 1982 to 2022 year-to-date.

The question is where do we go from here? Citi Global Wealth Investments (CGWI) sees the global economy slowing from about 5.6% in 2021 to just 2.6% in 2022 while the U.S. economy may slow from about 5.5% in 2021 to 1.9% in 2022. This type of slowdown alone was likely to lead to weaker equity markets than in 2021, but now investors also need to consider how aggressive the Federal Reserve will be in combating inflation through higher interest rates. With the Fed tightening monetary policy into a slowdown, both stocks and bonds have sold off throughout much of the year. In fact, this has been an historic sell-off in the sense that both stocks and bonds have each sold off by more than 10% over the past six months. However, that may present as opportunity as well.

We studied the past five times when both the S&P 500 and the 10-year U.S. Treasury sold off by more than 4.5% over a period of six months and looked at what happened during the following six months. What we found was that the S&P 500 averaged a gain of about 5.5% – rising in 3 out of the 5 cases – while the 10-year Treasury rallied in every instance with an average return of about 11% (see figure 3).

We realize that inflation took a step a backwards in May with the consumer price index (or CPI) rising from 8.3% to 8.6%, but we should not ignore that core inflation continued to slow from a peak of 6.5% to 6.0% in May. Rising rents, foods prices, and energy prices will likely keep the gauge elevated, but when excluded, prices have fallen from a peak of 7.6% in February to 6.4% in May – over a full percentage point in just a few months. We find that encouraging and a possible sign that we are still closing in on peak inflation with several retailers recently stating that they may need to slash prices on goods due to bloated inventories. Financial markets have subsequently abandoned the idea of a “September pause” from the Fed and are now pricing in three more 50-basis-point rate hikes this year (see figure 4). The odds of a 75 basis-point rate hike at this Wednesday’s Federal Open Market Committee (FOMC) meeting have risen but are still being placed at just 26% at the time of this writing.

While investors have put the possibility of an outsized rate hike (something larger than 50-basis-points) back on the table, we are hopeful that the Fed will eventually show a willingness to allow supply and demand forces to rebalance over time. Either way, we suspect that moving forward Treasury yields may react less to “upside” inflation surprises and more to “downside” growth surprises. If the U.S. economy is indeed headed towards a recession because the Fed is going to overtighten, then yields will likely fall as growth contracts. Likewise, if we look at total fixed income returns during past stock market corrections of over 20%, long-duration U.S. Treasuries were the best performing fixed income asset with an average total return of 12% (see figure 5). Even if yields haven’t peaked just yet, we still think that bonds are now a reasonable alternative to equities with yields having risen materially.

This line chart shows the number of Fed 25-Basis-Point Rate Hikes Expected by December 2022 from June 2021 to 2022 year-to-date. A "September pause" from the Fed now seems unlikely according to financial markets.

At the end of the day, this is really about supply and demand rebalancing after the earthquake that was COVID. We honestly can't think of a more visible display of the economic theory than what we are seeing today. Unfortunately, it is more nerve-wracking to live through than to read about, but we suspect that as time progress investors will learn yet another textbook example, which is that "time in the market is often more important than timing the market (see figure 6)."

What Should U.S. Investors Watch in the Week Ahead?

Investors will hear the results of the Fed's June FOMC meeting this Wednesday, June 15th. The consensus is still expecting the Fed to raise rates by 50-basis-points. Investors will also get fresh reads on retail sales, building permits, housing starts, and industrial production. While housing data are expected to show some weakness, industrial production data may show a further recovery on the supply side of the economy.

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