Governments and central banks did a remarkable job of avoiding a depression when economies locked down due to COVID-19. By providing individuals, businesses and governments with enormous and unprecedented financial support, the world experienced the shortest economic recession and fastest recovery on record.
Unfortunately, the success also fuelled a surge in inflation, which is currently running at rates last seen in the early 1980s. While the war in Ukraine has definitely added pressure, hugely expansionary fiscal and monetary policies were the primary fuels for rising prices. Authorities simply stimulated too much demand for goods and services at a time when the world was struggling with supply. It is elementary economics: prices rise when demand is greater than supply.
Inflation is universally disliked. When the cost of living rises faster than incomes, individuals struggle to make ends meet. Business leaders see profit margins squeezed when they can’t find workers and/or raise prices faster than costs. Investors become nervous and fearful because asset prices fall when inflation is out of control. Politicians naturally get blamed and risk losing their jobs. Central bankers face the unpleasant task of fixing inflation by raising interest rates.
Naturally, everyone would like to believe that inflation will abate without too much economic pain. Optimists point to significant drops in the price of things like gasoline, lumber and used cars as reasons to believe the authorities are winning the war against inflation. They are right, to a degree. However, realists appreciate that it’s the price of services – not goods – fuelling consumer price inflation today. The service sector is much larger than the goods sector, and there is a wage-price dynamic causing inflation to accelerate. Because the unemployment rate is low and job openings are plentiful, workers are getting significant pay increases. With those, workers can afford to pay more for goods and services, and companies are able to pass on higher costs. If jobs remain plentiful and pay raises continue, the cycle repeats. It’s hard to believe inflation will drop in such a scenario.
In the late 1970s and early 1980s, authorities were slow to appreciate the wage-price dynamic, and it got out of control. Inflation accelerated to very high levels, and the U.S. Federal Reserve ultimately had to raise administered interest rates to 20% to break the wage-price spiral and subdue inflation, causing nasty back-to-back recessions in 1980 and 1981.
Unfortunately, higher unemployment and an economic recession are likely the necessary evils needed to reduce inflation and put the world on healthier ground. The U.S. Federal Reserve and other central banks are aiming to bring demand and supply back into balance by increasing interest rates. Individuals and businesses borrow and spend less when interest rates rise, which ultimately results in people losing their jobs. Putting people out of work is harsh medicine indeed, but the alternative of letting high inflation persist would ultimately produce worse economic outcomes for everyone.
While investors fret about how much more central banks will increase rates and the dismal near-term outlook for the economy, we see several reasons to be optimistic about the long term.
First, we believe interest rates have already increased to levels that should produce a meaningful economic contraction and enough weakness in labour markets to arrest the wage-price spiral. The administered short-term interest rates, which are controlled by central banks and are the building blocks for all other rates, have increased dramatically. The U.S. Federal Reserve and the Bank of Canada have increased rates sharply from near zero to 3.25% in the U.S. and 3.75% in Canada this year alone. Meanwhile, market-based interest rates, including government and corporate bonds, mortgage rates, credit cards and auto loans, have increased much more. In fact, U.S. government bond yields are back to where they were during the 2008/09 financial crisis. Similarly, investment-grade corporate bond yields are at a 13-year high of 6.25%. High-yield bonds are close to 10%, which is very near the peaks in 2011 and 2016, and not much lower than the highs reached at the start of the pandemic in early 2020. Most extreme of all is the more than 7% interest rate on U.S. 30-year fixed-rate mortgages, the highest since 2000.
There is always a meaningful lag before changes in interest rates have an economic impact, but we believe the necessary and harsh medicine is already in the economic pipeline. Stocks are more sensitive to changes in market interest rates than administered central bank rates, and we doubt market rates will rise much further, if at all. Stocks may be near their bottom, if market interest rates are near their peak.
Stock prices are depressed, and investor sentiment is extremely negative – additional reasons to be constructive. According to the Bank of America’s latest monthly survey of global fund managers, professional investors are more bearish about stocks than at any time in the last two decades. Fund managers viewed the world as relatively safe at the beginning of the year, but now they see risks as elevated as they were in 2008. Sentiment regarding the outlook for corporate earnings is as negative as it has been since the survey started.
Negative sentiment is a positive from a contrarian perspective. The odds of generating attractive returns over a three to five-year horizon are always better when sentiment is gloomy and valuations are depressed, rather than when investors are optimistic and stock prices are near their highs.
While it might seem counterintuitive to invest when there is so much to worry about, it’s important to appreciate that the market is forward looking. Stocks, bonds and other assets have performed very poorly this year because investors know that getting inflation down requires tough economic action. They know conditions will get worse before they get better, and they have marked down stock prices accordingly.
In time, and perhaps soon, investors will come to realize that the medicine is working. By the time unemployment is rising and inflation is falling, the market will probably be anticipating a healthier economy, better corporate profits and higher stock prices.
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