May 27, 2022 Dave Wigginton

It goes without saying there’s a lot going on in the world right now. From a planning and investment standpoint, it’s been a volatile ride. The good news is it’s only been five months and we’re already seeing some signs the pressures that have been weighing on investment markets are ever so slightly easing, if only for a short period of time. Below are some of the key themes weighing on asset markets and some related thoughts and questions.

The Fed is on the warpath to slay inflation

What we know:

  • Higher rates and a reduction in the amount of assets the Fed owns are the primary tools being used. This tightening in monetary policy is being felt across all asset classes for better or for worse (mostly worse).

What we don’t know:

  • When the more restrictive (hawkish) tone and approach will soften and potentially reverse course. We’re already seeing some very slight changes in tone providing hope there may be a softening stance on the horizon. It’s too soon to make a call here. However, if inflation figures begin to slow then the Fed’s hawkish tone will likely soften.
  • Whether or not the Fed will do enough to get inflation back to more reasonable levels.
  • What the ultimate impact the reduction in the size of the Fed’s balance sheet will have on interest rates, asset prices, and the overall functioning of the monetary system. This is a key unknown as the impact has generally ended up being negative historically, causing the Fed to reverse course. It will be interesting to see if this time is different.

Economic growth is slowing

What we know:

  • We’re observing a slowdown in key economic data from retail sales to inventory builds to durable goods to the housing market. Commentary from management teams of public companies that are reporting results are suggestive an economic slowdown is under way. Whether that ends up being a recession remains to be seen. For the Fed to meaningfully slow inflation down, a recession may be necessary.

What we don’t know:

  • Will growth in the services sector of the economy be able to offset the slowing we’re observing in the goods sector of the economy?
  • What kind of impact will the Fed’s tight monetary policy and the resultant slowdown in growth have on inflation?
  • Will we actually get a recession and to what extent is that already reflected in prices?

The US government has a large fiscal deficit to fund

What we know

  • Tax receipts were up nicely in the first quarter which is a positive step to funding the national deficit.
  • Tax receipts will likely markedly decline in a recession
  • As of now, the Fed will not be buying treasuries
  • Liquidity issues in the Treasury market are manifesting themselves. As a reminder, liquidity is the ease at which an asset can be turned into cash without disrupting the price of that asset.

What we don’t know

  • Who will be the marginal buyer, in the absence of the Fed, of our nation’s debt?
  • If the marginal buyer doesn’t appear, will the Fed step in?
  • The impact on rates if the Fed doesn’t step in
  • The impact on rates if the Fed does step in
  • The impact on asset prices in the scenarios identified in the two previous bullet points

Stocks and bonds are both down year-to-date

What we know:

  • The S&P 500 is down over 13% year-to-date
  • The NASDAQ is down over 23% year-to-date
  • The Dow is down over 8% year-to-date.
  • The Bloomberg Global Bond Aggregate is down over 10% year-to-date

What we don’t know:

  • Is the decline in stocks and bonds over?
  • Will an inverse relationship between stocks and bonds be reestablished?
  • What kind of returns can we expect over the next several years? 

The US Dollar (USD) is strong right now relative to many currencies

What we know:

  • Demand for USD increases during turbulent times
  • A higher USD usually means lower stock and commodity prices
  • Commodity prices haven’t been as negatively impacted by a strong USD as they have been in the past

What we don’t know:

  • The ultimate impact a strong USD will have on foreign demand for US assets. Demand will wane but by how much is the question.
  • Will a strong USD result in foreigners selling US assets and converting back into their home currencies at a favorable rate?

This list is obviously not an exhaustive one. Other variables may take on greater importance and have more impact going forward. For now, it still appears the Fed is the most important variable for asset markets. If the Fed begins to articulate a change in course, then that would be a noteworthy shift in the backdrop for asset markets. However, if growth continues to slow it may not be enough.