You can’t predict the obstacles that will present themselves during the daily grind, but I had a whopper occur this month.
On a recent Saturday morning Carrie and I loaded our car with junk to jettison at the local landfill. As we placed an old carpet (that had been stored outdoors) in the vehicle, out jumped a toad landing in the floorboard.
I’ll forever tease Carrie for her startled scream over what turned out to be a rather modest-sized creature (I feared snake based on her reaction).
The toad situation quickly turned serious when the startled beast climbed up into a hole in the dashboard near the gas pedal.
We immediately recognized our problem. If the toad was not immediately extricated, it would likely crawl across my foot while driving and I’d wreck the car. If we close up the car and delay the landfill trip, the creature could later jump out from anywhere, scare the wife again and I’d wreck the car. Lastly, it could die in the dashboard and then the car smells for weeks.
I’m a professional problem solver yet this pickle left me dumbfounded for several minutes. It then occurred to me to turn on the car and fire up the heater. It worked, flushing out the toad in a manner of minutes. With a quick flip of a broom, the toad landed a double back flip on the pavement, problem solved. It left all three of us rattled but uninjured.
This story resonated with me as I crafted our mid-year 2022 outlook. In the dead of summer, investors face a “toad hiding in the dashboard” problems:
- Inflation: When will the rising costs of living normalize?
- Recession: When will it arrive and how deep will it be?
The current inflationary conditions are causing real misery, especially for working class families. It’s also wreaking havoc on investment portfolios. “The worst period for US bonds in history” and “worst start for US stocks in decades” are ugly recent financial headlines for sure.
There’s a real debate among pundits whether inflation has been caused by massive money printing during the COVID crisis, a serious labor shortage, fiscal stimulus overspending, global supply chain distributions and/or the Ukraine-Russia war. We believe all five factors are playing a meaningful role in the inflation misery.
Looking through the windshield, an economic “reset” is starting to form. New government stimulus spending bills are done, at least until 2025. The Fed Reserve, after printing trillions of dollars to finance government deficits and forcing interest rates to zero percent for too long, is now aggressively raising interest rates chasing the runaway inflation they helped foster with loose monetary policy.
COVID and the Ukraine-Russia war exposed how vulnerable the US has become to global supply shocks. It will take years to diversify away from Russia/China as trading partners and it will be inflationary.
Like a dead toad in a car, US inflation headlines will continue to stink to high heaven through the fall. Thereafter, inflation should start to moderate heading into 2023 yet remain elevated for the reasons referenced above.
There are some encouraging early signs of inflation moderation. Wage growth appears to be slowing. The price of copper, a key industrial commodity and economic bellwether, is down sharply since June. Building material costs are declining with the froth removed from the hot housing market by rising mortgage interest rates. Finally, indications are that China will be forced to cease severe COVID lockdowns, restart their economy and thus start to remedy the disruptive supply chain bottlenecks.
Finally, investors in longer dated US government bonds are not signaling that runaway inflation is a concern beyond the next couple years.
Russia-Ukraine war had an outsized inflationary economic impact in 2022 and may continue to do so for years. Global economic dynamics has been permanently changed in just matter of months; the winners/loses are yet unknown.
Rising short-term interest rates, an inverted yield curve and falling commodities portend a slowing US economy and there’s plenty of chatter about a looming recession.
In normal times, a recession stamps out inflation as economic demand recedes. The operative questions are when the recession will start and whether it will be shallow, normal or deep?
Right now, we expect the recession to start some time in 2H22 and will be “normal” in terms of severity and duration.
Despite many headwinds, a ray of optimism is the US labor market. Deep recessions can trigger substantial job losses, but they typically do not occur when the labor market is as robust as it is now. The US consumer is in okay financial shape and there’s no financial stress like the housing bubble of 2008. Remember the US consumer comprises 70% of the US economy.
Recessions are therapeutic as they clean out economic / market excesses, setting the stage for an economic recovery. Unfortunately, the stock market detests recessions, which explains some of the steep market sell off in 2022. A larger factor, however, was the stark jump in inflation and related bond market panic, which has kneecapped tech stocks, crypto currencies and other overvalued/bubbly financial assets.
We’re leery of investing fresh cash in US stocks at the moment. Stock valuations now look better, but the 2H22 corporate earnings outlook is cloudy and more market volatility is likely until the inflation story improves.
US bonds could see a modest rally with softening economic conditions, but their longer-term outlook remains lethargic.
In short, we’re hunkering down for the coming recession owning a diversified mix of well-managed, reasonably valued investments paying cash dividends.
We were too early on our emerging market equity call this past spring. The unnatural US dollar rally since the Ukraine/Russia war whacked non-dollar international investments. We plan to double down on our emerging market equity call as the US dollar value retreats from its current nosebleed levels. The dollar no longer deserves its reserve currency status and its days as such are numbered.
Until next time, be well...Tim