Weekly Market Insights 06.27.22
Bad News, Good Results
Financial Markets
Perhaps the title is a bit misleading, but it certainly rings true.
Equity markets rallied strongly this past week, with all sectors except Energy participating. The Dow gained 5.39%, the S&P 500 gained 6.45%, while the NASDAQ gained 7.49%. The interesting question is why? This is where our title comes in. The rally was precipitated by what normally would be considered bad news. Economic data was released that suggested the U.S. economy may be slowing down. Now, an observer from Mars with no other data would surely think a slowing economy is bad news for investors, so the rally is counter-intuitive. But the other factor is inflation and higher interest rates. Investors interpreted a slower economy to mean less pressure on prices and less reason for the Fed to raise interest rates. The logic makes sense, but these assumptions are being made on very little evidence. We have reminded readers that economic indicators are important but must be observed over time. We will reiterate our argument in the Economics portion, but wanted to remind readers about how to interpret economic indicators.
Economics
Last week’s economic data appeared to show signs of a slowing of the U.S. economy. As we wrote earlier, this would indicate less pricing pressure. The evidence is somewhat scarce, but we have written for a while that there are signs of peaking inflation data in the United States. Unfortunately, there are certain inflationary factors at present that do not have their genesis in economics and are impossible to forecast—food and energy shortages caused by the war in Ukraine.
Wage increases should slow as time erodes the effects of the COVID pandemic. There are a number of reasons for this. During the brunt of the pandemic, savings grew rapidly due to the considerable amount of income stabilizers used by the government to augment lost or reduced wages. While necessary to combat the massive rise in unemployment spurred by pandemic lockdowns, these stimulus measures may have created a disincentive to work, thereby reducing the supply of labor. The recovery in labor force participation has been slow, which has kept upward pressure on wages, but it now appears that supply is returning. Wages are an exceptionally important factor for the economy, and any change in the growth of wages will have a large effect on inflation.
Much has been written about supply chains, which are slowly returning to normal. The nature and structure appear to be changing, but any improvement will reduce price pressures.
Of course, the Federal Reserve has started to aggressively tighten money supply and raise interest rates, which should act to slow the economy and moderate price increases.
There are three important unknowns that investors and the Fed must watch closely—will the Fed overstay its welcome and force a recession, will global trade differences force a tariff war, increasing existing shortages, and what happens in Ukraine? Any or all of these issues could derail economic progress.
Conclusion
Our view is that, in the absence of an escalation of the war in Ukraine, the Fed will likely prevail in its fight against inflation. But, as we wrote in the body of this piece, they will need some help from the normalization of supply chains. What we wrote is a logical progression of how the future of the economy may unfold. We caution that none of this is written in stone, and a lot can happen that could change our views. We expect high levels of market volatility to persist.
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