Why Financial Markets Are Struggling

U.S. stock markets continue to struggle amid Fed policy shift, inflation worries, and recession risk. Will inflation persist for long? Will Fed policy result in a soft landing? Is a U.S. recession imminent?

Inflation

In mid-2021, Fed Chair Powell suggested inflation was going to be a temporary, transient issue. I wrote in Forbes.com in August 2021 that inflation would not be temporary, and that it would persist for quite some time (to read the article, click the link below). Inflation is created when demand is greater than supply.

Article: Inflation Surge To Continue: Here Are 3 Reasons Why

The chief cause of today’s inflation is the supply shortage caused by the pandemic. Businesses cannot find some needed raw materials and there is a shortage of workers. Coupled with higher gasoline prices, especially diesel fuel, profit margins are compressed. To learn why gas prices are rising, read, The Real Reason Behind Surging Gas Prices. Higher operating costs has reduced corporate profits, which has led to layoffs in some smaller trucking companies. Moreover, Walmart
WMT
, Target
TGT
, and other large retailers have reduced their forward estimates citing lower growth due to inflation and supply chain challenges. In short, the supply chain disruption will take some time to normalize.

The other cause of inflation is strong demand. Since the onset of the pandemic, the federal government has passed a series of bills which put money into the hands of businesses and consumers. This excess liquidity has contributed to strong demand. But there’s another reason. After a prolonged period of isolation and reduced social interaction, many people have simply had enough and are ready to get back to normal. Thus, inflation will persist for a while.

Federal Reserve Policy

Another factor, as important as inflation, is Fed policy. After more than 13 years of zero interest rates and an unprecedented expansion of the U.S. money supply, the Fed is changing course. In short, it is moving from an easy monetary policy to a tightening policy. This will lower demand in hopes of curbing inflation.

The Federal Reserve has already raised interest rates by 0.75% and will reduce its balance sheet (i.e. reduce money supply). These tightening measures are a stiff headwind for financial markets and a chief reason (along with inflation) that stocks have recently declined. Also, during the pandemic central banks around the world reduced their interest rates and increased their money supply. We’re about to experience the great unwinding of easy monetary policy. The most important question here in the U.S. is: Will the Fed go too far?

Recession Risk

What’s the risk of a recession? A recession is a business cycle contraction when there is a general decline in economic activity. The classic definition is two calendar quarters with negative GDP. The first quarter of 2022 saw GDP fall by 1.4%. If second quarter GDP is also negative, that will meet the classic definition. Is a recession imminent? I estimate the chance of recession in the U.S. at greater than 50/50 by the end of 2022 or sometime in 2023. Fed policy is a key. If the Fed tightens too much, a recession becomes much more likely.

Earlier this year, the Fed announced it would raise interest rates at each of its next several meetings. Since the Fed has stated it is data dependent in terms of future policy decisions, and since it cannot know what the data will look like in 3, 6, 9, or 12 months from now, why would they say a rate increase at each meeting will occur? I view the Fed’s statement as a trial balloon in which the Fed was testing to see how markets and the economy would react. Well, we now know the reaction was quite negative. Therefore, I wouldn’t look for the Fed to raise rates as much as previously stated.

The Bottom Line

Stocks will likely continue to struggle over the next several months or longer. If you are an investor who is withdrawing money from your portfolio, you should have enough cash (ex: money markets and CDs) to support these distributions without selling securities. For clients who are adding money to their portfolio, you should be very cautious about when and what to buy. For the rest, this is a time for patience. Markets fall and markets rise again. The main question is how long will current conditions persist? While no one can answer that, from decades of research in studying financial markets, I can state with confidence, this too shall pass.