Paulsen's Perspective

The fight against runaway inflation is intense, and recession fears are rampant. The stock market has collapsed while bond yields have surged, and the panicked Federal Reserve is rapidly catching up with 75-basis-point fed fund hikes. In addition, Putin’s invasion of Ukraine shows no end in sight, and the U.S. Supreme Court is now at war with the Executive Branch.

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“Quantitative Policy” by the Federal Reserve is a very recent addition to the monetary tool kit, and we are still learning about its significance. For example, does QT directly and consistently impact the money supply? Is it equivalent to raising the fed funds rate? Is QT really another substantial tightening force—or is its impact overstated? Unfortunately, nobody yet knows the answer to these questions. They will become understood only after many more years of data becomes available.

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The current inflation spike has already ended the bull market and is widely expected to end the economic recovery soon. Nonetheless, rather than a “cycle-ender,” the contemporary environment could alternatively play out as a “rate hiccup,” which often occurs as the Federal Reserve and bond vigilantes react to signs of overheated growth during a recovery.

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Higher energy and services prices caused the headline Consumer Price Index (CPI) to reach 8.6% in May, its highest level since 1981! Friday’s disturbing report has sent bond yields to new recovery highs and the S&P 500 into bear market territory. Yet, despite its ongoing persistence, as illustrated in the following pictorial, U.S. inflation is nonetheless likely topping out.

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There is widespread consternation that a recession is imminent because the Federal Reserve has been hesitant to act, which has left it woefully behind the curve in fighting inflation. Many fear the Fed will feel compelled to be extremely aggressive in contracting monetary policy, making a soft landing nearly impossible.

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Inflation continues to be the focal point for policy officials and the financial markets. Has inflation peaked yet? How fast will it come down? Will the Fed orchestrate a soft landing, or can inflation only be slayed by a recession? Finally, how will the stock and bond markets respond to such high inflation, particularly if the Fed is forced to raise interest rates significantly more and implement aggressive quantitative tightening?

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In 2022, the quintessential stock-market inflationary beneficiaries—energy stocks—have dominated leadership. However, defensive investments have also been popular in a turbulent overall market, including Utilities, Staples, Pharma, dividend aristocrats, high-quality stocks, and low-vol investments. On the flip side, investors have focused on the demise of new-era stocks within Technology and Communications Services, and the destructive impact of rising inflation on Consumer Discretionary stocks.

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The last four years have been a remarkably wild ride for stock investors. The S&P 500 Index has experienced unprecedented volatility but with fantastic overall results. That is, investors have simultaneously survived and enjoyed “Fantastic Volatility”—a stock market perhaps best described as VOLTASTIC!

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The surge in bond yields this year has certainly wreaked havoc across the economy. The abrupt and sizable rise in the yield structure has proven to be a shock for consumers, homebuyers, and businesses on Main Street; it has also been destructive for stock and bond investors on Wall Street. Although higher yields should help moderate inflation, they have slowed real economic growth and raised recession fears.

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Well, the drama is over. The S&P 500 reached the bear market threshold (at least intraday), slipping below the -20% Mendoza line. The concern now is how much lower it will go—and where and when a bottom may finally emerge.

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These are just some random remarks about a few unrelated concepts of interest.

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As illustrated by the accompanying chart, every post-WWII bull market has experienced at least one separate correction (defined as a market decline of at least 10% but less than 20%) before ending in a bear market (a drop of 20% or more). But today, the S&P 500 is knocking on the door of a bear-market collapse without having yet experienced an isolated correction.

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By the end of last year, the annual Consumer Price Inflation (CPI) rate soared to 7% and rose above 8.5% by March. So how did bond yields react to the biggest inflation surge in over 40 years? Since April 2021, the inflation rate has been greater than 4% and ended the year at 7%, yet the 10-year U.S. Treasury yield was only 1.5% as of December and is currently just 2.9%—the lower end of U.S. history. Indeed, looking back to 1872, today’s inflation rate is higher than 88% of the time, whereas the 10-year Treasury yield is still lower than about 80% of the time!

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Could the recent surge in bond yields finally be reaching a standstill? Who knows for sure, but there are some encouraging signs signaling at least a temporary intermission?

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Consumers have enjoyed some positives in the last year, including a strong jobs market and rising wages. Overall, however, they have faced an increasing array of challenges that have dampened spirits. Fiscal stimulus has run dry, budgets have been pressured by a price upswing in nearly everything, interest rates are much higher, and despite elevated wages, the real wage rate has been declining. In addition, the headlines have turned increasingly dark: a protracted war in Ukraine, yet another COVID-variant upwelling, a potential policy mistake by the Federal Reserve, a stock market collapse, and widespread talk of an imminent recession.

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Lately, “TECH” has truly become a “Four Letter Word.” After a prolonged leadership run that began long before the pandemic, and became dominant in early 2020, technology stocks have entered a bear market. The S&P 500 Technology index and Nasdaq 100 (the QQQ) are now off from record highs by over -20% and -22%, respectively. This has left many wondering whether the financial markets are again headed for a replay of the 2000 dot-com collapse. 

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As the following chart pictorial illustrates, several key ingredients that underlie pricing pressures are losing their inflationary force. These include the systemic impact of rising inflation expectations, the coincident contribution of higher commodity prices, and the leading influence of economic policies. There is also notable progress among several supply-chain problems, including a surge in the U.S. labor supply, improvement in international freight rates, a rollover in backlog orders, and evidence that companies are finally rebuilding inventories.

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With so much worry swirling around contemporary Federal Reserve actions and imminent recession risk, history provides a good reminder that Fed-tightening cycles have almost always taken considerable time before bringing about a recession.

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For stock investors, the most important issue surrounding the inflation environment is not how high it is nor how long it may stay above the Fed’s target rate. Rather, it is whether inflation is nearing a recovery peak: Even if it remains elevated for some time, if inflation is nearing a top, the stock market has historically produced satisfying results. That is, stocks have done well in periods following a peak in the inflation rate. Consequently, today, with inflation this extreme (and probably close to topping out), it’s time to buy!

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We worry so much about the Federal Reserve. How far are they behind the curve? When will they start taking away the punch bowl? Is the fed funds rate alarmingly below the Taylor Rule? How fast will the Fed push interest rates higher? Will they opt for a 50 basis-pointer? Maybe multiple 50s? Could there be an intra-meeting hike? What is the terminal yield target? QT could be a killer! Do those dot-plots suggest a curve inversion? Oh my, even the Doves are Hawkish!

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