Weekly Market Insights 08.01.22
Reversal or Bear Market Bounce?
Financial Markets
Last week was truly a remarkable one for financial markets, capping off the best month for stocks since November 2020. All Dow sectors rose significantly while fixed income yields fell. As a reminder, fixed income yields and prices have an inverse relationship. This was widely welcomed by most investors. The question, of course, is, why? The answer to this question implies several different courses of action for investors. There are three good reasons to contemplate. 1) Investors felt the market had fallen too far too fast and needed a positive correction. 2) The Fed signaled a coming pause to its aggressive tightening. 3) The most welcome reason— investors believed inflation has peaked and the economy will slow without falling into a recession.
Unfortunately, there is no certain answer. It is clear that the Fed would like to curtail its current aggressive tightening, but their moves will be dictated by future inflation. It is improbable that inflation will fall to an acceptable range within the next six months, so the Fed will likely continue to tighten money supply. In our view, the inflation will continue to slow, but we may experience occasional blips to the upside.
The Economy
Interest rates are moving higher and inflation is taking its toll on the economy. Statistics tell us that consumers are feeling the pinch and consumption is starting to slow in response. The country has experienced two negative quarters of GDP, which many consider is the technical definition of a recession. At this point, the most likely outcome is that the recession will be a mild one. However, for this to be the case, the Fed must not tighten too aggressively, and we must hope that there is no unexpected escalation of the war in the Ukraine.
It appears as if some positive economic legislation will be enacted. Most interestingly, Congress and the executive branch appear to be coming to an agreement that there is a certain criteria of good that stands between a public and private good. A public good is one that is necessary for the public, but is uneconomic to produce, so the government steps in. A private good is one that is economically viable to produce. There are some goods that stand in between, where government must help private industry to produce. Some examples are police departments, most roads, bridges, and national defense. Although we applaud trade and globalization in a world characterized by occasionally fragile supply chains, actions which may appear counterproductive may be necessary. The products we are specifically writing about are rare earth materials and semiconductors.
The elephant in the room when we are writing about this, of course, is China. As it continues its progression from a poor, undeveloped country to a mid-level economic country, China has become the most important producer of many goods that the United States is dependent on for defense. While supported by Smith’s and Ricardo’s arguments of comparative advantage, as readers are well aware, China is not a reliable partner, so there is more to the economic relationship. Therefore, the United States should take two steps to protect itself—not rely on a single source of supply and develop domestic capabilities. The United States appears now to be addressing both.
Conclusion
After a strong stretch in the markets, investors must give serious thought to what, if anything, last week’s gains are telling them. Certainly, the week’s bullish run got many of the shorts to run for cover. Whether this is the end of the bear market or not won’t be answered this week, but it is making investors rethink what is going on. Clearly, the economy continues to face problems, inflation leading the pack. The Fed, however, has demonstrated its resolve to fight inflation with substantial rate hikes. We continue to believe that the Fed will not back down until there is clear evidence that inflation is under control. We agree that, almost surely, the United States has entered a recession, but it is not likely to be a severe one.
A longer-run view is, as the recession retreats and the economy starts to accelerate, new leadership may arise, leading to a strong recovery. Even though positive steps are being taken, investors should expect continued market volatility.
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