Weekly Update 5.14 Finding a Tailwind During Inflationary Headwinds

This week we witnessed a pickup in volatility. Perhaps it was the CPI reading which showed a dramatic increase in inflation—6.2% year over year and 0.9% month over month. Maybe it was fallout from the Colonial Pipeline hacking. Or, maybe, it was recent changes in CDC guidelines causing a further unwind of the lockdown trade. Whatever the cause, markets certainly were a bit jittery this week.

On Monday, the S&P 500 dropped nearly 1%. Tuesday the large-cap index fell another 0.9%. By the end of day Wednesday the market had fallen another 2.1%, bringing the losses for the 3-day period to nearly 4%. Fear seemed to be grabbing hold of the market. By Wednesday, the Cboe Volatility Index (VIX) had risen 65% versus Friday’s closing level. Perhaps, despite the Federal Reserve’s jawboning that current inflation is “transitory” was falling on deaf ears on Wall Street. However, yesterday the market stabilized and recovered 1.2%. Early market action today sees the S&P 500 up another 1%. Should the market hold these levels we will have experienced just a modest decline of less than 2%.

The increase in market volatility should be somewhat unsurprising. The higher and faster market’s rise the greater likelihood for sharp corrections. High valuations cause uneasiness among investors. Picture a game of musical chairs, everyone is expecting the music to stop and thus are apprehensive about finding an empty chair. The higher markets climb, like the game of musical chairs, the shorter the music plays. No one has ever accused me of being Pollyannaish. Consequently, I see many signs of froth and remembrances of things past. When I hear people throughout the day mention Dogecoin I can’t help but think this is a crazy bubble. When Elon Musk goes on SNL my bubble radar goes to 11.

In my career I have experienced unchecked euphoria—I have seen booms and busts. One thing, though, that I haven’t experienced is runaway inflation. The last time the CPI saw a 0.9% month over month gain was 1982, I was 9. 1982 was pretty much the tail end of a 13-year inflationary period. While the Federal Reserve’s policy targets a 2% inflation rate, they state they are willing to let it run hotter than that rate for a time being. They remain confident that they can easily curtail any unwanted inflation at any time. Some may see that as encouraging, others may read that as hubris, I fall in the latter camp. Throughout the 1970’s inflation in the US frequently reached double digits. The Fed, at that time, was late trying to control inflation. Still the 10-year US Treasury rate rose from 6% to over 10% between 1969 and 1980.

Hiking interest rates is the only tool to control inflation. Currently 8% of the federal budget consists of interest payments on existing debt. Current plans in Washington call for increasing our debt through more stimulus projects. Should these plans go forward, we will see even greater deficits that need to be funded by government borrowing. That, alone, poses a problem. But the problem that is not discussed is what will happen should our borrowing costs rise dramatically. Should we be forced to raise rates, or should the markets raise rates on their own by pulling all demand for Federal debt obligations at current levels, we will see interest payments as a percentage of federal budget skyrocket. While the Fed may think, at this time, that they will act to curb inflation, I doubt they will feel the same at the time action is required.

So, we may be on the verge of a very different regime that we have lived under since the early ‘80’s. Lower interest rates and lower inflation seem to have run their course. We cannot have our cake and eat it too. I have heard it said that the early stages of inflation always feel great, but it is the later stages where pain resides. Unfortunately, I do not know when that transition takes place. Stocks may not be the worst place in times of inflation, but the winners may look different than the winners of the past.

Employing an adaptive, momentum-based strategy should help adjust to new environments. Choosing winners from losers, a priori, may prove challenging as we have not seen a similar environment for 40 years. Implementing a strategy which reacts to environmental shifts should help when separating the winners from the losers of the new regime.

Thanks for reading,

Zach and Dave

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