U.S. Stocks Plummet Amid Worse Than Expected Inflation Data

After several days of rising performance, U.S. stocks are headed lower. Most attribute the decline to the August inflation rate, which was higher than expected. The annual rate was 8.3% for August, down slightly from a reading of 8.5% in July, but higher than the expected 8.1%. Moreover, since markets hate uncertainty, stocks are selling off today. Is this temporary or a longer-lasting trend? To attempt to answer this, we must consider what we know is coming and how investors might react.

Inflation, Fed Policy, And Recession

Despite falling oil and gas prices, inflation continues to be elevated. The fear is that it may prompt the Fed to be more aggressive in raising rates and reducing the money supply. Yes, the economy is very strong, unemployment is low, but there are sign that things are slowing. It just didn’t show up in the August inflation number.

The Fed has raised its target range for the fed funds rate from 0% to 0.25% earlier in the year to a current range of 2.25% to 2.50%. With today’s inflation reading, the fear is that the Fed might become even more aggressive. There’s an old Wallstreet saying, “You don’t fight the Fed.” In short, when the Fed is easing, invest. But when the Fed is tightening financial conditions, it’s best to lighten up on stocks. While I admit timing the market is rife with peril, we should consider the more major issues that affect stock market performance. So, what’s to come?

Again, it’s difficult to say with a high degree of certainty, but stock investors will likely experience a bumpy ride over the next 6-12 months. The timing is possibly the most uncertain element here. Higher interest rates and a smaller money supply will reduce loan growth and economic activity. No question on that. However, will the Fed go too far and push the economy into recession?

Globally, most of the world’s central banks are on a similar path as the U.S. Federal Reserve. For example, Europe, the U.K., and India are all raising interest rates. China, however, is not. Europe is facing a potentially serious energy crisis when the weather turns cold. This is because Europe only produces about 42% of its energy needs (CY 2020) and imports 58%. A significant amount of Europe’s energy need was supplied by Russia. Since Russia has closed the Nord Stream 1 Pipeline, Europe is forced to replace this lost energy. All of this argues for a more severe recession in the EU region.

When you consider a stronger U.S. dollar, which will reduce U.S. exports, an aggressive Fed policy, and a potentially severe recession in the EU and possibly elsewhere, U.S. exports should fall, corporate revenue and earnings should decline. This raises the risk of a widespread recession. That said, stocks could face a bumpy ride, in general, over the next year or so. Should you lighten up on your stock exposure?

Possibly, but there are many factors to consider. Large cap stocks should outperform small cap stocks through the end of the year. This has historically been the case according to Ed Yardeni. I consider him to be one of the more credible analysts out there. If, or perhaps when, the economy slows, interest rates may head higher, which could cause stock investors to move into bonds to reduce risk.

There is much uncertainty in today’s financial markets. But isn’t that usually the case? What we cannot say is when stocks will bottom or how long it will take until conditions are favorable again. While it’s far from certain if the Fed will bring the U.S. economy in for a soft landing – avoiding a recession or a very mild one is possible. I’m skeptical about this based on history and the Feds tendency to over tighten and push the economy into recession. Therefore, it might be prudent to prepare for bumpy times ahead as the global economy resets from the pandemic stimulus and subsequent fallout.