1Q23 Market Letter: A Drive Down Analogy Alley to Metaphor Manor

By Ryan Ross on January 27, 2023

Throughout the last year, we have used various analogies to describe inflation, the rate of increase in prices over time, and the Federal Reserve’s response to it. 

• Inflation is an economic disease, the Fed is a doctor, and higher interest rates is the medicine.  
• The Fed is a surgeon that needs a scalpel, but only has a handsaw. 
• Inflation is like steering a cruise ship; not immediately responsive and prone to overcorrection. 

We’ve been trying to convey that the institution in charge of maintaining price stability, the Fed, has only blunt instruments that take a long time to work. 

Another of our favorite analogies is driving looking in the rearview mirror. This intones that the Fed has to make decisions about the future by analyzing data from the past. We have a situation where the Fed is using a crude tool (interest rates) that acts with a long and variable lag, and is susceptible to overshooting because it relies on stale data. What could go wrong? If you give a kid a hammer, eventually something breaks.

We highlighted in our previous Market Letter that the imbalance of too much demand for the available supply in early 2021 ignited inflation like a match on dry powder.  Around Thanksgiving 2021, the Fed recognized its error and quickly reversed course. As they say, when you find yourself in a hole, the first thing to do is stop digging. What resulted was a frenetic tightening of financial conditions by quickly raising interest rates and decreasing the balance sheet. This immediate about-face shocked the partying markets into a nasty hangover. As the punchbowl was removed and the lights turned on, investors got a good look at their dance partners and didn’t like what they saw. High-flying tech stocks and low-yielding bonds dropped like a rock. Those beautiful, disruptive growth stories couldn’t sustain their ebullient valuations when the free-money party ended. The paltry bond yields of yesteryear were no match for new issues sporting mid-single digit coupons. Usually a hedge against stock market volatility, bonds also dropped double digits on their way to a historical annus horribilis.

In the fourth quarter of last year, we witnessed a solid market recovery as inflation somewhat subsided and economic growth remained positive. Looking forward, unemployment is low and consumers are working down their savings, supporting an economy being weighed down by higher financing costs. The Fed plans to stop raising interest rates soon, but will likely keep them at a high level to see how the economy evolves. Remember, long and variable lags in policy transmission to the real economy. The Fed is trying to thread the needle, by reducing demand just enough to match supply, without wrecking demand and inducing an economic recession. It all feels like a race against time. 

However, the market is not the economy. Even if we can avoid an economic recession, we do not see a lot of near-term upside to the stock market. Profit margins are high versus history and we expect them to continue downward, hurting profits. Also, for the first time in ages, higher-yielding bonds are now an attractive alternative to risky stocks. On the flip side, we do not see any major problems for companies. Banks have been responsible lenders and are highly capitalized, reducing the risk of a financial crisis. Housing prices are soft, but that risk is manageable. Equity valuations have come down across the board, limiting further downside. Add it all up and we expect a sideways, range-bound, highly volatile market. The market goes up like an escalator and down like an elevator, so any hint of persistent inflation or lower economic activity will send stocks swooning. This will continue until the inflation genie is back in the bottle. For now, we think the all-time highs are safe from challenge, but we’d be surprised to see another huge leg lower unless things deteriorate significantly. As always, we will remain vigilant.    Helping clients understand the economy’s roller coaster ride of emotions – that’s HMA!